Chapter 4 Demand and Behavior in Markets. Impersonal Markets Impersonal markets Prices: fixed and predetermined Identity & size of traders – doesn’t.

Chapter 4

Demand and Behavior in Markets

Impersonal Markets Impersonal markets

Prices: fixed and predetermined Identity & size of traders – doesn’t matter

Consumers represented by Utility function/ preference map income

•2

The Problem of Consumer Choice Maximize utility

Indifference curve tangent to budget line MRS = price ratio

On budget line

Quantity demanded of a good People seek to purchase at a given price

•3

Optimal consumption bundle

•4

B

B’F

Goo

d 2

(x 2

)

20

Good 1 (x 1)0 20

I1

I2

I3e

x1 + x2 = 20

Income Expansion Paths Income expansion path

Changes in quantity demanded Changes in income Constant prices

Connected optimal consumption bundles MRS = slope of budget line

•5

•6

D

D’

Good 1 (x 1)0 604020

Goo

d 2

(x

2)

60

40

20

C

C’

B

B’

Income expansion path

r

s

e

Inferior and Superior Goods Superior good

Income increase Demand increases Constant relative prices

Inferior good Income increase

Demand decreases Constant relative prices

•7

Superior and inferior goods

•8

Good 1 (x 1)0

Goo

d 2

(x

2)

(a)

Good 1 (x 1)0G

ood

2 (x

2)

(b)

Homothetic Preferences Homothetic preferences

Indifference curves Do not “rotate” as consumer’s income

increases Along any ray from the origin

MRS – constant Increase in income

Proportional increase in goods purchased All goods are superior No change in tastes

•9

•10

D

D’

Good 1 (x 1)0 604020

Good 2 (x

2)

60

40

20

C

C’

B

B’

Income expansion path

r

s

e

Price-Consumption Paths Price-consumption path / curve

Consumption changes One price changes All other prices – constant Consumer’s income – constant

•11

Price-Consumption Paths Changing relative prices

Optimal bundle Indifference curve tangent to budget line MRS = Price ratio

Good 1 – relatively less expensive Rotation of budget line – flatter

Good 1 – relatively more expensive Rotation of budget line – steeper

•12

•13

As the price of good 1 decreases while the price of good 2 remains constant, the budget line becomes flatter, rotating around its point of intersection with the

vertical axis (point B).

B*

40 Good 1 (x 1)0

Good 2 (x

2)

20

20 B

B’

10

B”

e1

-1

1/2 2

•14

As the price of good 1 decreases while the price of good 2 remains constant, the budget line becomes flatter, rotating around its point of intersection with the

vertical axis (point B).

B*

40 Good 1 (x 1)0

Good 2 (x

2)

20

20 B

B’

10

B”

e1

-1

1/2 2

15

Price-consumption path

•15

As the price of good 1 varies, the price-consumption path traces the locus of tangencies between budget lines and indifference curves.

B*

Good 1 (x 1)0

Good 2 (x

2)

B

B’B”

ef

g

ba c

Demand Curves Demand curve

Relationship between Quantity demanded Price As the price varies Other things constant

Image of the price-consumption path Generated: utility-maximizing behavior

•16

Demand curve for good1

•17

The demand curve for good 1 associates the optimal quantity of good 1 with its price, while holding income and other prices constant.

Good 1 (x 1)0

Price

ba c

p1=2

p1=1

p1=1/2

Demand and Utility Functions Nonconvex preferences

Optimal consumption bundle At the corner of the feasible set

Maximize utility Spend all income on only one good

Demand curve If price > p*, quantity = 0 If price = p*, quantity > 0 As price decreases, quantity increases

•18

Non convex preferences and demand

•19

Indifference map.

Nonconvex preferences imply optimal consumption bundles at the corners of the feasible set—either point h or point k.

Good 1 (x 1)0

Goo

d 2

(x

2)

(a)

Demand curve.

Nonconvex preferences imply jumps in the demand curve.

Good 1 (x 1)0

Price (b)

B

B’

e

f

k

p*

p1*

g*

B*

h

Decomposing the Effects of a Price Change Substitution Effect: change in

consumption caused by a change in relative prices

Income Effect: change in consumption as a result of a change in the budget set

•20

Substitution Effect Change in demand due to substitution

One good (decreasing price) For another good (constant price)

The substitution effect from the decline in price always increases demand

•21

Income Effect Income effect

Decrease in price is equivalent to an increase in real income

The income effect from the decline in price will cause demand to Increase if the good is normal Decrease if the good is inferior

•22

•23

The income effect of the price change is measured by the parallel shift of the budget line from DD’ to BB”. The substitution effect is measured by movement around the indifference curve from e to g.

Good 1 (x 1)0

Good 2 (x

2)

(a)

Downward-sloping demand curve

Good 1 (x 1)0

Price (b)

B’

B

B”

I1

e

D’

D

g I2

f

p”p’

Substitution effect Income effect fe

p”

p’

Inferior Goods: Income and substitution effects work on opposite directions

•24

The substitution effect of a decline in the price of good 1 causes an increase in demand for the good, the move from e to g. Because good 1 is an inferior good, this is partly offset by the income effect, a decrease in demand for the good from g to f .

Good 1 (x 1)0

Good 2 (x

2)

B’

B

B”

I1

e

D’

D

g

I2

f

Substitution

effect Income effect

How does the demand curve for good 1 look

like?

Giffen Goods and Upward-SlopingDemand Curves

Giffen good Upper sloping demand curve Inferior good A price decrease

Substitution effect Increase demand

Income effect Decrease demand

Dominant effect: income effect

•25

Giffen good

•26

The decline in the price of good 1 causes a decline in the demand for that good because the substitution effect (the move from e to g) is more than offset by the income effect (the move from g to f ).

Good 1 (x 1)0

Good 2 (x

2)

B’

B

B”

I1

e

D’

D

g

I2

f

Substitution

effect

Income effect

Identifying normal and Giffen goods

•27

Type of good

Substitution effect Income effect

Normal downward sloping D

Opposite to price change

The good is either superior or inferior but with an income effect that is less powerful than the substitution effect.

Giffen Upward sloping D

Opposite to price change

The good is inferior. The income effect is more powerful than the substitution effect.