Consumer Equilibrium and Market Demand Chapter 4

Discussion Topics Conditions for consumer equilibrium Changes in equilibrium The law of demand Tastes and preferences Consumer surplus 2

Measurement and Interpretation of Consumer Equilibrium 3

Consumer Equilibrium Remember that utility represents the level of satisfaction with alternative bundles or collection of goods Assume the consumer wants to maximize utility given his/her limited budget Utility only impacted by the level of consumption of market goods How can we represent this problem graphically and mathematically? Page 54

Consumer Equilibrium Point A is consumer equilibrium → Slope of Indifference Curve = Slope of Budget Line →MRS12= – P1/P2 → At A, MU1/MU2 = P1/P2 → At A, on the boundary of the budget set and on highest indifference curve Good 2 Increasing Utility U4 U2 A G2* Budget Constraint ($C*) U3 U1 U1 < U2 < U3 < U4 G1* Good 1 Previously: Slope of Indifference Curve =MRS Slope of budget line = price ratio 5 Page 54

Consumer Equilibrium Point A can be interpreted as the combination of goods that generates The maximum utility (U3) While being limited by a fixed budget ($C*) Good 2 Increasing Utility U4 U2 A G2* U3 U1 G1* Good 1 6 Page 54

Consumer Equilibrium Point A can also be interpreted as the combination of goods that generates The minimum cost ($C*) While generating a desired level of utility (U3) Good 2 C3* C1*< C2*< C3* C2* C1* A G2* U3 Good 1 G1* Why are these parallel shifts of the budget constraint? 7 Page 54

Consumer Equilibrium We can rearrange the above equilibrium conditions: → the marginal utility derived from last dollar spent on each good, MUi/Pi, is identical This can be expanded to include all goods and services purchased by the consumer Lets extend this to the textbook example of tacos vs. hamburger consumption 8 Page 54

Utility is maximized by buying 5 tacos @ $0.50 2 hamburgers @ $1.25 Total expenditures equals the weekly budget of $5.00 Consumer Equilibrium 9 Page 54

Points B and D exceed the $5 budget How can you tell? Consumer Equilibrium Points B and D exceed the $5 budget How can you tell? 10 Page 54

Consumer Equilibrium Page 54 Point C does not maximize utility How can you tell? Page 54 11

Consumer Equilibrium What happens to the above consumer equilibrium when the price of one of the products changes? Will the consumption of both commodities change even though only 1 price impacted? Lets assume the price of Hamburgers (PH) changes $5.00 $1.25 (Current Price) $1.00 Page 54 12

Effect of Price Changes Budget Line ED: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium: 5 Tacos 2 Hamburgers 11 E 10 9 8 7 6 Taco Consumption per Week A 5 4 3 2 1 D 1 2 3 4 5 6 Page 54 Hamburger Consumption per Week 13

Effect of Price Changes Budget Line EF: Price of Hamburgers (PH) = $1.00 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium: 4 Tacos 3 Hamburgers 11 E 10 10 9 8 7 6 Taco Consumption per Week A 5 B 4 3 2 1 F D 1 2 3 4 5 6 Page 54 Hamburger Consumption per Week 14 14

Effect of Price Changes Budget Line EG: Price of Hamburgers (PH) = $5.00 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium: 5 Tacos 0.5 Hamburger 11 E 10 9 8 7 6 Taco Consumption per Week C A 5 B 4 3 2 1 F D 1 2 3 4 6 Page 54 Hamburger Consumption per Week 15 15

Effect of Price Changes Line CAB represents a consumer demand schedule for hamburgers Shows how the consumer responds to changes in a good’s price ↑ in price, ↓ in quantity demanded 11 E 10 9 8 7 6 Taco Consumption per Week C A 5 4 B 3 2 1 F D 1 2 3 4 6 Page 54 Hamburger Consumption per Week 16 16

Effect of Price Changes Lets collect the equilibrium points for the three hamburger price scenarios We can then graph the quantity purchased at each price level Vertical axis is price Horizontal axis is quantity Referred to as the demand curve for hamburgers Equilibrium Point PH ($/lb) QH (No.) C $5.00 0.5 A $1.25 2.0 B $1.00 3.0 Page 54 17 17

Consumer Equilibrium This graph shows the demand curve for hamburgers PH($/Burger) What is the relationship between price and quantity demanded? $5.00 ̶ C A $1.25 ̶ B $1.00 ̶ ̶ ̶ ̶ QH(Burgers) 0.5 2.0 3.0 Page 54 18

Effect of an Income Change Budget Line KJ: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00 11 K 10 9 8 7 Original Equilibrium 6 Taco Consumption per Week A 5 4 3 2 1 J 1 2 3 4 5 6 Page 54 Hamburger Consumption per Week 19 19

Effect of an Income Change 13 G 12 Budget Line KJ: Income = $5.00 BudgetLline GF: Income = $6.00 11 10 K 9 New Equilibrium Both hamburgers and tacos are normal goods as budget increased from $5 to $6/week Normal goods are goods whose demand increases with higher budget (income) and decreases with lower budget (income) 8 7 6 Taco Consumption per Week B 5 A 4 3 Original Equilibrium 2 1 J F 1 2 3 4 5 6 Page 54 Hamburger Consumption per Week 20 20

Effect of an Income Change Budget Line KJ: Income = $5.00 Budget Line GF: Income = $6.00 Budget Line ED: Income = $8.00 16 E 15 14 13 12 G Tacos become an inferior good when budget (income) increased to $8/week Inferior goods are goods whose demand ↓ with ↑ in the budget and ↑ with ↓ in the budget 11 10 K 9 8 7 B 6 Taco Consumption per Week A 5 C 4 3 2 1 D F J 21 1 2 3 4 5 6 21 Page 54

Effect of an Income Change We can plot demand levels under alternative budgets (income) Referred to as an Engel Curve 13 12 G 11 10 K 9 8 7 B 6 Taco Consumption per Week A 5 C 4 3 2 1 D F J 22 1 2 3 4 5 6 22 Page 54

Equilibrium Impacts of Income Changes Hamburger Engel Curve Tacos Engel Curve Typical shape of a normal good’s Engel curve over all income levels Example of an Engel curve for a good that is an inferior good at higher income (budget) levels Page 58 23

Measurement and Interpretation of Market Demand 24

Concept of Market Demand The above model of consumer behavior has focused on a single individual We can extend the above model to one where we refer to overall or total market demand for a city, county, state, country, etc. as a whole 25

Concept of Market Demand Notice the kink The market demand curve for a good is the horizontal summation of demand schedules for all the consumers in the particular market In the above example with PH = $1.50 Paula purchases 2 hamburgers/week while Beth purchases 1 hamburger → market demand = 3 hamburgers @ a price $1.50/hamburger 26 Page 59

Demand Curve Description When discussing events in the market place economists use specific terms to distinguish between movement along a demand curve vs. a shift in a demand curve Movement along a demand curve referred to as a change in quantity demanded Only 1 demand curve, just a different point on it Alternatively a shift in the demand curve referred to as a change in demand Need not be a parralel shift in the demand curve 27

Movement from point A to C is referred to as a change in demand Movement from point A to B is called a change in quantity demanded Page 61 28

Demand Curve Description Reasons for a change in a demand curve Change in household income Change in population characteristics Number of children Change in marital status Household composition Price of substitutes 29

Concept of Consumer Surplus A characteristic of market demand curve Concept of consumer surplus (CS) or economic well-being CS is derived from consumption and the fact we have a negatively slope demand curve A demand curve reveals the willingness of consumers to pay a certain price for a particular quantity of a good 30 Page 63-64

Concept of Consumer Surplus As we showed earlier, consumers are willing to pay a higher price for a lesser quantity Actually do not have to pay the higher price given the level of supply coming into the market → Consumers realize a savings $ P2 > P1 Q2 < Q1 B P2 A P1 Q Q2 Q1 31 Page 63-64

Quantifying Consumer Surplus $ Area ABC is the consumer surplus when price is $6. Demand curve implies consumers are willing to pay $10 for the 1st unit, $9 for the 2nd unit, etc. Only had to pay $6 each for all 5 units 11 B 10 9 8 7 A C 6 5 D E Area DACE is the gain in consumer surplus if the price falls to $5 4 3 2 1 Q Page 63 1 2 3 4 5 6 7 8 9 10 11 32

Quantifying Consumer Surplus $ The level of consumer surplus is [(H × L)/2], or (($11-$6)×5)/2=$12.50 11 B 10 9 8 7 A C 6 5 D E 4 3 2 1 Q Page 63 1 2 3 4 5 6 7 8 9 10 11 33

In Summary Consumer equilibrium for an individual for a given price and budget Individual consumer’s demand schedule Market demand curve Engel curves Change in demand vs. change in quantity demanded Consumer surplus

Chapter 5 examines the concept of an elasticity, one of the most important concepts in all of economics….