CHAPTER 2 DEMAND AND SUPPLY ANALYSIS: CONSUMER DEMAND Presenter’s name Presenter’s title dd Month yyyy

1. INTRODUCTION Build the model with simplifying assumptions Develop the implications of the model Compare the model’s implications with the real world Copyright © 2014 CFA Institute 2 The development process of an economic model

2.CONSUMER THEORY: FROM PREFERENCES TO DEMAND FUNCTIONS Consumer choice theory is the part of economics in which we focus on consumer demand and consumer preferences. -It addresses consumers’ tastes and preferences. -It examines the trade-offs that consumers make between or among goods. -It delves into the choices consumers make, given a set of prices, when consumers have limited income. -The limit on income is the budget constraint. Models of consumer choice: -Do not seek to explain why consumers have the tastes and preferences that they have, but rather why they make the choices they do given their tastes and preferences. -Focus on the aggregate behavior of consumers, not that of an individual consumer. Copyright © 2014 CFA Institute 3

3.UTILITY THEORY: MODELING PREFERENCES AND TASTES The consumption bundle (or consumption basket) is the set of goods and services that the consumer would like to consume. Axioms of the theory of consumer choice: 1.We assume that a consumer can make a choice between any two bundles— the assumption of complete preferences. -The consumer prefers one to another or is indifferent between the two. -We refer to this as complete preferences: Consumers are able to make comparisons and choices. 2.We assume that consumers’ preferences are transitive preferences. -If a consumer prefers Bundle A to Bundle B and prefers Bundle B to Bundle C, then the consumer prefers A to C if preferences are transitive. 3.We assume that there is nonsatiation for at least one good. -There is never too much of that good. Copyright © 2014 CFA Institute 4

THE UTILITY FUNCTION Copyright © 2014 CFA Institute 5

INDIFFERENCE CURVES We can represent preferences with indifference curves, which represent the utility of each possible combination of a given set of goods and services. -Because the utility is the same throughout a given curve, the consumer is indifferent between the combinations on a curve. The marginal rate of substitution is the rate at which a consumer will give up one good or service in exchange for another and still have the same utility. The indifference curve map is a graphical representation of the possible indifference curves, one for each level of utility. Copyright © 2014 CFA Institute 6 Good A Good B Curve 1 Curve 3

4. THE OPPORTUNITY SET: CONSUMPTION, PRODUCTION, AND INVESTMENT CHOICE Copyright © 2014 CFA Institute 7

PRODUCTION FUNCTION AND INVESTMENT OPPORTUNITY SET The production opportunity frontier represents the different quantities of two goods that a company can produce, considering the trade-off between the two goods in terms of manufacturing facilities. -Analogous to the budget constraint for a consumer. The investment opportunity set is the set of investment opportunities that an investor may invest in. Copyright © 2014 CFA Institute 8

5. CONSUMER EQUILIBRIUM: MAXIMIZING UTILITY SUBJECT TO THE BUDGET CONSTRAINT Copyright © 2014 CFA Institute 9 Consumers prefer more utility to less and thus will want the bundles of goods that maximize utility, given the budget constraint. Looking at a his or her utility function, the consumer will choose the bundle of goods that maximizes the utility (the indifference curve farthest from the origin) within a given budget constraint. Step 1 Determine the consumer’s preferences (utility). Step 2 Determine the budget constraint. Step 3 Determine the bundle of consumer goods that maximizes utility given the budget constraint.

NORMAL VS. INFERIOR GOODS A normal good is a good that a consumer buys more of with increases in income. An inferior good is a good that a consumer buys less of with increases in income. Income effects: -As income increases, the consumer has a larger budget, and therefore, the optimal bundle changes, resulting in a higher proportion of the normal good and a lower proportion of the inferior good. Substitution effect: -Substitution effects are movements along an indifference curve. -Substitution with income effects: If one of the prices changes (relative to the price of another), the budget line changes slope and the new bundle of goods is along the same indifference curve, but a different bundle (tangent to new line). Copyright © 2014 CFA Institute 10

6.REVISITING THE CONSUMER’S DEMAND FUNCTION Change in real income without price changes Parallel shift in the budget line Change in real income from a price change Change in the slope of the budget line Substitution without any change in real income Movement along the indifference curve Copyright © 2014 CFA Institute 11

INCOME AND SUBSTITUTION EFFECTS Copyright © 2014 CFA Institute 12 Income effects: When income rises, the demand for normal goods increases. When income rises, the demand for inferior goods falls. Quantity of Inferior Good Quantity of Normal Good

BREAKING DOWN INCOME AND SUBSTITUTION EFFECTS Copyright © 2014 CFA Institute 13 A change in the price of a good will result in a change in the real income of the consumer. The change in demand from this change is the substitution effect. A change in income results in an increased demand for normal goods, and a decreased demand for an inferior good. Quantity of Inferior Good Quantity of Normal Good C A B When the price of an inferior good falls, the budget constraint pivots upward Substitution effect = Q B – Q A Income effect = Q C – Q B QAQA QBQB QCQC

SPECIAL CASES OF DEMAND A Giffen good is an inferior good for which the income effect outweighs the substitution effect. -Lowering the price of a Giffen good will result in a decrease in its demand. -Raising the price of a Giffen good will result in an increase in its demand. -A Giffen good is an inferior good, but not all inferior goods are Giffen goods. -There are few Giffen goods. A Veblen good is a good for which the demand increases as the price of the good increases. Copyright © 2014 CFA Institute 14

7. CONCLUSIONS AND SUMMARY Consumer choice theory and utility theory help us understand consumer preferences. A consumer’s marginal rate of substitution represents the rate at which the consumer will trade one good for another. What a consumer can spend (i.e., the budget) depends on the consumer’s income, and what a consumer buys depends on the prices of goods and the consumer’s preferences (i.e., utility). A consumer’s equilibrium is the point of tangency between the consumer’s budget and marginal rate of substitution. We can break down changes in demand related to income and substitution effects. -The income effect is the response in demand for a good when income changes. -The substitution effect is the response in demand for a good when the relative prices of goods change. -When relative prices change, there may be both an income effect (i.e., change in real income) and a substitution effect. Copyright © 2014 CFA Institute 15

7. CONCLUSIONS AND SUMMARY A normal good is a good whose demand increases when income increases (and falls when income falls). -A Veblen good has a perverse demand: The more is demanded of the good, the higher the price of the good. An inferior good is a good that generally has a decrease in demand as income increases. -An extreme case of an inferior good is a Giffen good, for which an increase in price results in an increase in demand. Copyright © 2014 CFA Institute 16