CHAPTER 5 Consumer choice and demand decisions ©McGraw-Hill Education, 2014.

CHAPTER 5Consumer choice and

demand decisions

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Four key elements in consumer choice

• Consumer’s income

• Prices of goods

• Consumer preferences

• The assumption that consumers maximize utility

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The budget line

• 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).

Consider a student with abudget of £50 to spend on meals and films.

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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.

Quantityof meals

Quanti

ty o

f fi

lms

a

b

c

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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

Quanti

ty o

f fi

lms

b

c

Preferredregion

Dominatedregion

e

d

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• 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

Modelling consumer preferences (3)

Quantityof meals

Quanti

ty o

f fi

lms

U2

U2

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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.

Quantity of meals

Quanti

ty o

f fi

lms

BL

C

E

B

The point at which utility is maximized is found by bringing together the indifference curves (U) and the budget line (BL)

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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.

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Normal goodsWhen both goods areNORMAL, an increasein income induces a newchoice point at C‘.

The quantity demandedof each good increases.

Meals

Film

s

BL0

BL1

C

C'

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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 andthe quantity of films increases

Meals

Film

s

BL0

BL1

C

C'

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Adjustment to a price change

• An increase in the price of one good shifts the

budget line

– altering its slope

– which reflects relative prices.

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An increase in the price of meals (1)

The increase in price of meals shifts the budget line from BL0 to BL1

The increase in price reduces purchasing power.

Meals

Film

s

BL0BL1

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An increase in the price of meals (2)

Meals

Film

s

BL0BL1

CE

The consumer moves from C to E as the price of meals rises

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.

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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.

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The SUBSTITUTION EFFECT is from C to D along U2U2. E

The substitution effect

Meals

Film

s

BL0BL1

C

H

D

H

The hypothetical budget line HH has the slope of the NEW relative prices and is tangent to the OLD indifference curve at D.

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.

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E

The income effect

Meals

Films

BL0BL1

C

H

D

H

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.

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Income and substitution effects for an inferior good

MealsBL0BL1

C

E

H

D

H

Films 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.

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Income and substitution effects for a Giffen good

MealsBL0BL1

C

E

H

D

H

Films 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.

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Given A'e1F’, the best the

individual can do is e1.

Film

s

e2

The individual can now be better off at e2.

e1

An equivalent cash transfer gives a budget line of A'e1F'.

QF

Transfers in cash and in kind

QM10

F

A

14

Meals

e0

AF is the initial budget constraint

on which the individual settles at e0.

Ae1F' is the new budget constraint.

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Market

24

Consumer 2

13

Deriving the market demand curve

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, and consumer 2 demands 13 units, then market demand at a price of £5 will be 24 units.

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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.

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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.

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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.

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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.

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