Chapter 5 Consumer choice and demand decisions David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximise utility See Section 5-1 in the main text.

The budget line Consider a student with a budget of £50 to spend on meals and films. Assume also that Pfilm = £10; Pmeal=£5 A B C D E F G Income and prices together determine the combinations of the goods that the consumer can afford. The budget line separates the affordable from the unaffordable. Slope BL = relative prices = Pmeal /Pfilm = PX /PY See Section 5-1 in the main text

Modelling consumer preferences Quantity of meals Quantity of films a b c Assume the consumer prefers more to less. Compared with point a: the consumer would prefer to be to the north-east, e.g. at c but prefers a to such points as b to the south-west. See Section 5-1 in the main text

Modelling consumer preferences (2) Quantity of meals Quantity of films a b c Preferred region Dominated e d a is preferred to all points in the dominated region but the consumer would prefer any point in the preferred region to a points like d and e involve more of one good and less of the other compared with a. See Section 5-1 in the main text

Modelling consumer preferences (3) An indifference curve like U2U2 shows all the consumption bundles that yield the same utility to the consumer ICs slope downwards (given our assumptions) their slope gets steadily flatter to the right ICs cannot intersect Quantity of meals Quantity of films U2 See Section 5-1 in the main text

Characteristics of Indifference Curves ICs slope DOWNWARDS (given our assumptions) If they were to slope upwards, As one moves upward along the IC, the consumer would be consuming more and hence increasing her utility. This would be against the definition of the IC. Hence IC’s canNOT slope upwards. Quantity of meals Quantity of films U2 Wrong! See Section 5-1 in the main text

Characteristics of Indifference Curves their slope gets steadily flatter to the right This is due to the assumptionof DIMINISHING MARGINAL UTILITY: the more the consumer consumes of one good, the less the utility she derives from the consumption of each additional unit of that good. i.e. The more meals she has, the more hungry she becomes for films, and vice versa. Slope IC = MRS og good Y for good X = ∆ no of films/ ∆ no of meals Quantity of meals Quantity of films U2 See Section 5-1 in the main text

Characteristics of Indifference Curves ICs cannot intersect Otherwise, the consumer would be indifferent between consumption bundles B and C; (as they both lie on U1U1) indifferent between consumption bundles C and D; (as they both lie on U2U2) Yet B would be preferable to D (as B lies to the Northeast of point D) which is impossible Quantity of meals Quantity of films U2 U1 B D C See Section 5-1 in the main text U1

The consumer’s choice U2 U3 U1 The point at which utility is maximised is found by bringing together the indifference curves (U) and the budget line (BL) U3 Quantity of meals Quantity of films U2 U1 BL C E B The choice point is at C where the budget line is at a tangent to an IC Points B and E are also affordable but give lower utility, being on a lower IC. See Section 5-1 and Figure 5-6 in the main text.

Adjustment to an income change A change in the consumer’s income shifts the budget line without changing the slope The change in the pattern of consumer choice depends on the nature of the two goods See Section 5-2 in the main text.

Normal goods Films When both goods are NORMAL, an increase U2 U1 Meals Films BL0 BL1 C C' When both goods are NORMAL, an increase in income induces a new choice point at C' The quantity demanded of each good increases See Section 5-2 and Figure 5-8 in the main text.

An inferior good and a normal good Meals Films BL0 BL1 U2 U1 C C' When “meals” is an inferior good the increase in income takes the consumer from C to C' The quantity of meals falls and the quantity of films increases See Section 5-2 and Figure 5-9 in the main text.

Adjustment to a price change An increase in the price of one good shifts the budget line altering its slope which reflects relative prices. See Section 5-3 and Figure 5-10 in the main text.

An increase in the price of meals (1) The increase in price of meals shifts the budget line from BL0 to BL1 Meals Films BL0 BL1 See Section 5-3 and Figure 5-10 in the main text. The increase in price reduces purchasing power.

An increase in the price of meals (2) U1 E The consumer moves from C to E as the price of meals rises Films The overall effect is a reduction in quantity of meals demanded C U2 See Section 5-3 and Figure 5-10 in the main text. H BL1 BL0 Meals Tracing out more of such points at different prices enables us to identify the Demand curve.

Response to a price change The response to a price change comprises two effects: The SUBSTITUTION EFFECT is the adjustment to the change in relative prices THE INCOME EFFECT is the adjustment to the change in real income. See Section 5-3 and Figure 5-11 in the main text.

The substitution effect D The hypothetical budget line HH has the slope of the NEW relative prices and is tangent to the OLD indifference curve at D. Films U2 U1 The SUBSTITUTION EFFECT is from C to D along U2U2. C E See Section 5-3 and Figure 5-11 in the main text. U2 It is always negative. In this case an increase in the price of meals leads to a fall in demand as we move from C to D. U1 BL1 BL0 Meals

The income effect The INCOME EFFECT is from D to E Meals BL0 BL1 U2 U1 C E H D Films it reflects the fall in real income at constant relative prices it may be positive or negative depending on whether the good is normal or inferior See Section 5-3 and Figure 5-11 in the main text.

Income and substitution effects for an inferior good The INCOME EFFECT is from D to E H Films in this case, it is positive because the good is inferior and income and substitution effects therefore have opposite effects on demand but the substitution effect is greater, so the overall effect is a fall in demand D C See Section 5-3 in the main text. U2 E H U1 BL1 BL0 Meals

Income and substitution effects for a Giffen good The INCOME EFFECT is from D to E Films in this case, it is positive because the good is inferior and income and substitution effects therefore have opposite effects on demand but the substitution effect is smaller, so the overall effect is an increase in demand H D C U2 See Section 5-3 and Figure 5-12 in the main text. E U1 H BL1 BL0 Meals

Transfers in cash and in kind 10 F A  AF is the initial budget constraint QF An equivalent cash transfer gives a budget line of A'e1F' A'  e0  On which the individual settles at e0 e2  The individual can now be better off at e2 14 e1 F'  Ae1F' is the new budget constraint  Given A'e1F’, the best the individual can do is e1 Films See Section 5-6 and Figure 5-16 in the main text. QM Meals

Deriving the market demand curve The market demand curve is the horizontal sum of the individual demand curves Consumer 1 5 11 If at a price of £5, consumer 1 demands 11 units Market 24 then market demand at a price of £5 will be 24 units. Price Consumer 2 13 and consumer 2 demands 13 units See Section 5-4 in the main text. Quantity