1. Consumer Choice and Related Issues
Lecture 4
Consumer Choice and
Related Issues

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

3. 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

4. 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.

5. Graphical illustrationPp q d1 P d2 d3
d1000 D Q
D = d1 + d2 + d3 + d4 … … … d1000 q P Q

6. 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

7. 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

8. 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

9. 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!

10. 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

11. Decomposing the SE and IEX2
Optimal bundle is Ea, on indifference curve I1. Ea I1 xa X1

12. 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

13. 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)

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

15. Draw a line parallel to the new budget line and tangent to the old indifference curveX2 Eb Ea U2 U1 xa xb X1

16. 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

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

18. 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.

19. 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

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

21. 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)

22. 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?

23. 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

24. 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

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

26. 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

27. 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?

28. 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

29. 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