1. © The McGraw-Hill Companies, 2008 Chapter 5 Consumer choice and demand decisions David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. © The McGraw-Hill Companies, 2008 Utility (1) Utility is a measure of happiness. However, we cannot say that one apple can make me twice as happy as one banana. So, utility is not a cardinal measure. We can easily say that I like apple more than banana. This kind of measure is called an ordinal measure.

3. © The McGraw-Hill Companies, 2008 Utility (2) Total utility of eating five slices of pizza is the total happiness we get from eating all pizzas. If you are talking about eating the first, second, third, etc. slices of pizza, we are talking about the marginal utility. As you consume more pizzas, the total utility increases, however, the marginal utility decreases.

4. © The McGraw-Hill Companies, 2008 Example QxTUxMUx 0 1 1010 2 188 3 246 4 284 5 302 6 300 7 28 -2 4 The total and marginal utility of good x.

5. © The McGraw-Hill Companies, 2008 Why the Demand Curve is Downward Sloping When you consume a good little, the marginal utility of the extra unit is high. Therefore, you are willing to pay a higher amount for the additional unit. MWP is the inverse function of demand. As you consume more, the MU decreases. 5

6. © The McGraw-Hill Companies, 2008 Optimal Consumption The solution which gives the maximum utility is as follows: On the margin, the marginal utility per lira you get should be equal for all goods. 6 MU X1 = MU X2 P x1 P x2

7. © The McGraw-Hill Companies, 2008 Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximise utility

8. © The McGraw-Hill Companies, 2008 Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximise utility

9. © The McGraw-Hill Companies, 2008 The budget line Income and prices together determine the combinations of the goods that the consumer can afford. The slope of the budget line is the ratio of the prices. (relative price) If the income increases, the budget line shifts parallel to the right. Consider a student with a budget of £50 to spend on meals and films. A B C D E F G Price of meals is £5; price of films is £10.

10. © The McGraw-Hill Companies, 2008 Modelling consumer preferences 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. Quantity of meals Quantity of films a b c

11. © The McGraw-Hill Companies, 2008 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 region e d

12. © The McGraw-Hill Companies, 2008 An indifference curve like U 2 U 2 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 Modelling consumer preferences (3) Quantity of meals Quantity of films U2U2 U2U2

13. © The McGraw-Hill Companies, 2008 Marginal Rate of Substitution. The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good. The MRS decreases as you consume more of that good. This is called decreasing MRS.

14. © The McGraw-Hill Companies, 2008 The consumer’s choice 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. U3U3 Quantity of meals Quantity of films U2U2 U2U2 U1U1 U3U3 U1U1 BL C E B The point at which utility is maximised is found by bringing together the indifference curves (U) and the budget line (BL)

15. © The McGraw-Hill Companies, 2008 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

16. © The McGraw-Hill Companies, 2008 Normal goods When both goods are NORMAL, an increase in income induces a new choice point at C' The quantity demanded of each good increases U2U2 U1U1 Meals Films BL 0 BL 1 C C'

17. © The McGraw-Hill Companies, 2008 An inferior good and a normal good 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 Meals Films BL 0 BL 1 U2U2 U1U1 C C'

18. © The McGraw-Hill Companies, 2008 Adjustment to a price change An increase in the price of one good shifts the budget line –altering its slope –which reflects relative prices.

19. © The McGraw-Hill Companies, 2008 An increase in the price of meals (1) The increase in price of meals shifts the budget line from BL 0 to BL 1 The increase in price reduces purchasing power. Meals Films BL 0 BL 1

20. © The McGraw-Hill Companies, 2008 An increase in the price of meals (2) Meals Films BL 0 BL 1 U2U2 C U1U1 E The consumer moves from C to E as the price of meals rises H The overall effect is a reduction in quantity of meals demanded Tracing out more of such points at different prices enables us to identify the Demand curve.

21. © The McGraw-Hill Companies, 2008 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. More Expensive: Buy less THE INCOME EFFECT –is the adjustment to the change in real income. Higher income, buy more of the normal goods, buy less of the inferior goods. Total change in the consumption of the goods are determined by adding up these two effects.

22. © The McGraw-Hill Companies, 2008 Deriving the market demand curve Market 24 then market demand at a price of £5 will be 24 units. Quantity Price 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 Consumer 2 13 and consumer 2 demands 13 units