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Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximize utility ©McGraw-Hill Education, 2014 2

©McGraw-Hill Education, 2014 The budget line Consider a student with a budget of £50 to spend on meals and films. Income and prices together determine the combinations of the goods that the student can afford. The budget line separates the affordable (A to F) from the unaffordable (G). ©McGraw-Hill Education, 2014 3

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. ©McGraw-Hill Education, 2014 4

Modelling consumer preferences (2) 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. Quantity of meals Quantity of films a b c Preferred region Dominated e d ©McGraw-Hill Education, 2014 5

Modelling consumer preferences (3) Quantity of meals Quantity of films U2 An indifference curve (IC) 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 ©McGraw-Hill Education, 2014 6

©McGraw-Hill Education, 2014 The consumer’s choice The point at which utility is maximized 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. ©McGraw-Hill Education, 2014 7

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. ©McGraw-Hill Education, 2014 8

©McGraw-Hill Education, 2014 Normal goods 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. ©McGraw-Hill Education, 2014 9

An inferior good and a normal good Meals Films BL0 BL1 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 U2 U1 ©McGraw-Hill Education, 2014 10

Adjustment to a price change An increase in the price of one good shifts the budget line altering its slope which reflects relative prices. ©McGraw-Hill Education, 2014 11

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 The increase in price reduces purchasing power. ©McGraw-Hill Education, 2014 12

An increase in the price of meals (2) Films E The consumer moves from C to E as the price of meals rises The overall effect is a reduction in quantity of meals demanded C U2 U1 BL1 BL0 Meals Tracing out more of such points at different prices enables us to identify the demand curve. ©McGraw-Hill Education, 2014 13

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. ©McGraw-Hill Education, 2014 14

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 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. U2 U1 BL1 BL0 Meals ©McGraw-Hill Education, 2014 15

©McGraw-Hill Education, 2014 The income effect H D The income effect is from D to E. 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. Films U2 U1 C E U2 U1 BL1 BL0 Meals ©McGraw-Hill Education, 2014 16

Income and substitution effects for an inferior good H The income effect is from D to E. In this case, it is positive because the good is inferior. 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. Films D C U2 E H U1 BL1 BL0 Meals ©McGraw-Hill Education, 2014 17

Income and substitution effects for a Giffen good The income effect is from D to E. In this case, it is positive because the good is inferior. 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. Films H D C U2 E U1 H BL1 BL0 Meals ©McGraw-Hill Education, 2014 18

Transfers in cash and in kind  F A QF AF is the initial budget constraint on which the individual settles at e0. Ae1F' is the new budget constraint.  A' e2    Given A'e1F’, the best the individual can do is e1. e0 e1  Films An equivalent cash transfer gives a budget line of A'e1F'. The individual can now be better off at e2. F’  10 14 QM Meals ©McGraw-Hill Education, 2014 19

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, and consumer 2 demands 13 units, then market demand at a price of £5 will be 24 units. Price Market 24 Consumer 2 13 Quantity ©McGraw-Hill Education, 2014 20

©McGraw-Hill Education, 2014 Revealed preference Consumers’ preferences are determined by observing consumers behaviour. Suppose that a consumer faces two bundles, X and Y. If the consumer chooses X when also Y was affordable, then we may say that bundle X is revealed preferred to Y. If our consumer behaves according to our theory, then we should expect her/him to always choose X instead of Y when both bundles are affordable. ©McGraw-Hill Education, 2014 21

Revealed preference (2) If we see our consumer choosing Y instead of X it should be the case that X has become not affordable, otherwise our consumer does not behave according to our theory. The important aspect of revealed preferences is that if consumer behaviour satisfies some properties (known as the axioms of revealed preferences), then the consumer is indeed a utility maximizing agent. ©McGraw-Hill Education, 2014 22

Concluding comments (1) Given the budget constraint, the theory of demand assumes a consumer seeks to reach the maximum possible level of utility. The budget line shows the maximum affordable quantity of one good for each given quantity of the other good. Consumer tastes can be represented by a map of non-intersecting indifference curves. Utility-maximizing consumers choose the consumption bundle at which the highest reachable indifference curve is tangent to the budget line. ©McGraw-Hill Education, 2014 23

Concluding comments (2) A change in the price of one good generates an income effect and a substitution effect. The income effect of a price increase is to reduce the quantity demanded for all normal goods. The substitution effect leads consumers to substitute away from the good whose relative price has increased. The market demand curve is the horizontal sum of individual demand curves, at each price adding together the individual quantities demanded. ©McGraw-Hill Education, 2014 24