1. Part 4 The Theory of Demand
We have drawn all our demand curves downward sloping
Why do economists think demand curves normally slope downward?
Market demand curves are aggregations of individual (or household) demand curves
What factors will affect a household’s demand for a good?

2. Household Consumption Choices
Households buy a variety of goods (a “bundle” of goods)
Different households buy different bundles of goods
Household choice will depend on:
- income
- relative prices of goods
- preferences
Income and prices can be shown in a budget constraint
What shapes preferences?
How can a given set of preferences be represented?

3. Budget Constraint Qy Unaffordable Affordable Qx
Budget constraint with given income = I
and given prices Px and Py:
I = PxQx + PyQy

4. Preferences and Utility
Which of the affordable combinations will a household choose to purchase?
The intuitive answer is that the household will choose the bundle of goods that it “likes the best” or provides the most satisfaction of all the affordable bundles
More formally, if the degree of satisfaction of all wants and desires can be measured on a single “utility” scale, the household will choose the bundle of goods that maximizes utility

5. Cardinal Utility Theory
When the idea of a utility measure was first proposed in economics it was sometimes assumed that one could think of units of utility in the same way as units of weight or temperature
Such a measure has a defined unit that can be added, multiplied, & etc
Many possible units of measure but they are all linear transformations of each other (eg: deg F = /5 C)

6. Total and Marginal Utility
More goods give more total utility
More of any particular good will tend to give less additional total utility with each increment
Diminishing marginal utility
Diminishing marginal utility and the “paradox of value”
What is the rule for maximizing total utility out of a given budget when each good has diminishing marginal utility?

7. Maximizing Utility Quantity MUx MUy 1 20 16 2 18 15 3 14 4 8 13 5 12
Example of two goods x and y
Quantity
MUx
MUy 1 20 16 2 18 15 3 14 4 8 13 5 12
Utility maximizing bundle with an income
Of $6 and Px and Py= $1?
$16 and Px=$3 and Py=$2

8. Maximizing Utility
The total utility gained from a given budget will be maximized where the budget is all spent and marginal utility per dollar spent is equalized across all goods
Rules for a utility maximum:
I=PxQx+PyQy and
MUx/Px = MUy/Py or
MUx/MUy = Px/Py

9. Implications Maximization is where I=PxQx+PyQy and MUx/Px = MUy/Py
Fall in Px will increase ability to purchase X and Y. If X is normal Qx increases.
Fall in Px leads to a substitution of X for Y
Increase in Qx decreases MUx
Decrease in Qy increases MUy

10. Individual and Market Demand
Market demand curves are the horizontal summation of the demand curves of all individuals or households

11. Ordinal Utility Theory
The idea of utility as measurable in a cardinal way was subject to much criticism
The idea of a utility measure as a rank ordering replaced the idea of cardinal measurement
An “ordinal” measure is a ranking only.
No unit of measurement
Higher numbers imply only more preferred

12. Preferences If both X and Y provide utility Qy Definitely Preferred to
A: U>5 Y’
Definitely
Less preferred
to A: U<5
Bundle A: X’,Y’
U=5 Qx X’

13. Indifference Curves A locus of all bundles with the same
utility ranking. The consumer is indifferent
between them Qy
Indifferent between any point on U=5
U>5 (preferred to
Any point on U=5)
U<5
(any point on U=5 preferred)
U=5 Qx

14. A Preference Map Qy d c a
U=6 b
U=5 Qx

15. Preference Maps
In order to draw a preference map at all we are assuming:
goods are infinitely divisible (indifference curves are continuous)
Every combination of goods can be ranked (preferences are complete)
Preferences are consistent (indifference curve cannot intersect or touch)

16. The Shape of Indifference curves
Negative slope (more is preferred to less)
Marginal rate of substitution (MRS)
Convex to the origin (diminishing marginal rate of substitution)
MRS=ΔQy/ΔQx keeping utility constant—slope of the indifference curve

17. Maximizing Utility Once Again
In the ordinal utility context maximizing utility means choosing that bundle of goods that is on the highest indifference curve achievable with given income and prices
Budget line: I = PyQy+PxQx
PyQy = I- PxQx
Qy = I/Py – (Px/Py)Qx
I/Py is the Y intercept
Px/Py is the slope of the budget line

18. Budget line I = PyQy+PxQx Px/Py is the slope of the budget line Qy
I/Px Qx
Px/Py is the slope of the budget line

19. Utility Maximization: Indifference CurvesQy
Highest indifference curve
achievable
Qy*
U=6
U=5
U=4
Qx* Qx
Budget line and indifference curve are tangent.
On budget line and highest indifference curve
where MRS=Px/Py

20. Changes in Income
Changes in income with constant prices will shift the budget line outwards in a parallel fashion
Normal goods will show increased consumption with higher income
Inferior goods will show decreased consumption with higher income
Consumer preferences determine if a good is normal or inferior (shape of indifference curves)

21. Income Effect Qy I” X and Y normal I’ Income consumption line U” U’
Qx’
Qx” Qx Qy
X inferior, Y normal U” I” I’ U’ Qx
Qx”
Qx’

22. Changes in Price
Change in the price of X changes the slope of the budget line by changing the X intercept Qy
Px’>Px”
I/Py Qx
I/Px’
I/Px”

23. Price Effect and Demand CurvesQy
Budget line
with Px’
Budget line
with Px” U” U’ Qx
Qx’
Qx” Px
Px’
Px”
Demand curve for X Qx
Qx’
Qx”

24. Income and Substitution Effects of a Price Change
The effect of a price change on the demand for a good can be decomposed into two effects
The substitution effect is the effect of the change in relative prices keeping real income (utility) constant
The income effect is the effect on real purchasing power of the price change

25. Income and Substitution Effects of a Price ChangeQy
Overall effect (a to b) can be
broken down into a substitution
and income effect a b s
Qx’
Qxs
Qx” Qx
Sub
Inc

26. Income and Substitution Effects of a Price Change
Income effects of a price change are usually small--unless the good accounts for a high proportion of expenditure
For normal goods the income effect works to reinforce substitution effect and a price decline must increase quantity demanded
For inferior goods the income effect works against the substitution effect, but the substitution effect is usually larger

27. Income and Substitution Effects of a Price Change
What does it take to get an upward sloping demand curve? The “Giffen” good case
Giffen goods must be both inferior and important in the budget
Very unlikely to come across a Giffen good
Policy uses of income and substitution effects--carbon taxes and income tax rebates