Consumer Equilibrium and Market Demand Chapter 4.

ConsumerEquilibriumand Market

Demand

Chapter 4

Discussion Topics

What are the conditions that describe your initial purchase decision?

What makes you change your purchase decision?

A representation of the law of demandWhat is meant by tastes and

preferencesUse of consumer surplus for benefit

calculation2

Measurement andInterpretation of

Consumer Equilibrium(Purchase Decision)

3

Consumer EquilibriumRemember that utility represents the level

of satisfaction obtained from alternative bundles (or collection) of goods

Assume the consumer wants to maximize utility given his/her limited budget We also assume that utility only impacted by

the consumption of market goods (i.e. price exists)

How can we represent this problem graphically and mathematically?

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Incr

easin

g Util

ity

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Consumer Equilibrium

Good 1

Good 2

U4

U2

U3

U1U1 < U2 < U3 < U4

Budget Constraint ($C*)

A

G1*

G2*

Point A is consumer equilibrium→ Slope of Indifference Curve

= Slope of Budget Line→MRS12= – P1/P2

→ At A, MU1/MU2 = P1/P2

→ At A, on the boundary of the budget set and on highest indifference curve

Previously: Slope of Indifference Curve =MRS Slope of budget line = price ratio

5

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Consumer Equilibrium

Good 1

Good 2

U4

U2

U3

U1

A

G1*

G2*

Point A can be interpreted as the combination of goods that generates The maximum utility (U3)While being limited by a

fixed budget ($C*)

Incr

easin

g Util

ity

6

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Consumer Equilibrium

Good 1

Good 2

U3

A

G1*

G2*

Point A can also be interpreted as the combination of goods that generates The minimum cost ($C*)While generating a desired

level of utility (U3)

Why are these parallel shifts of the budget constraint?

C1*

C2*

C3* C1*< C2*< C3*

7

Consumer EquilibriumWe can rearrange the above equilibrium

conditions:

→ the marginal utility derived from last dollar spent on each good, MUi/Pi, is identical

This can be expanded to include all goods and services purchased by the consumer

Lets extend this to the textbook example of tacos vs. hamburger consumption Page 54

1 1 1 1 1 2

2 2 2 2 1 2

MU P MU P MU MU

MU P MU P P P

8

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Consumer EquilibriumConsumer Equilibrium Utility is maximized by

buying 5 tacos @ $0.50 2 hamburgers @

$1.25 Total expenditures

equals the weekly budget of $5.00

Utility is maximized by buying 5 tacos @ $0.50 2 hamburgers @

$1.25 Total expenditures

equals the weekly budget of $5.00

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$5 initial budget

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Consumer EquilibriumConsumer Equilibrium

Points B and D exceed the $5 budget How can you tell?

Points B and D exceed the $5 budget How can you tell?

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Consumer EquilibriumConsumer Equilibrium

Point C does not maximize utility

How can you tell?

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Consumer EquilibriumWhat happens to the above

consumer equilibrium when the price of one of the products changes? Will consumption of both goods

change even though only 1 price impacted?

Lets assume the price of Hamburgers (PH) changes $5.00 $1.25 (Current Price) $1.00

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Effect of Price Changes

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D

Hamburger Consumption per Week

Tac

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Under original budget line ED: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium:

5 Tacos 2 Hamburgers

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A

E

Effect of Price Changes

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D

Hamburger Consumption per Week

Tac

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Budget Line when PH decreases from $1.25, EF: Price of Hamburgers (PH) = $1.00 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium moves from A to B:

4 Tacos 3 Hamburgers

F

B

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10

A

5

E

Effect of Price Changes

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Hamburger Consumption per Week

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A

Budget Line when PH increases to $5.00, EG: Price of Hamburgers (PH) = $5.00 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium moves from A to C:

5 Tacos 0.5 Hamburger

C

G

Effect of Price Changes

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Hamburger Consumption per Week

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AC

Line CAB represents a consumer demand schedule for hamburgers Shows how the consumer responds to

changes in a good’s price ↑ in price, ↓ in quantity demanded Other prices and total expenditures do not

change

Only hamburger price changing

Lets collect the equilibrium points for the three hamburger price scenarios

We can then graph the quantity purchased at each price levelVertical axis is priceHorizontal axis is quantityGraph referred to as the demand curve for

hamburgers Page 54

Equilibrium Point

PH ($/lb)

QH (No.)

C $5.00 0.5

A $1.25 2.0

B $1.00 3.0

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Effect of Price Changes

Consumer EquilibriumThis graph shows the demand curve

for hamburgers

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PH($/Burger)

H̶

H̶H̶

QH(No. of Burgers)H̶ H̶H̶

C

A

B

0.5 2.0 3.0

$5.00

$1.25$1.00

What is the relationship betweenprice and quantity demanded?

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Pts. C, A and B correspondto same points on Slide 16

Effect of an Income Change

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K

Hamburger Consumption per Week

Tac

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Original Budget Line, KJ: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00

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A

Original Equilibrium:5 tacos/2 hamburgers

Effect of an Income Change

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Hamburger Consumption per Week

Tac

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Budget Line KJ: Income = $5.00Budget Line GF: Income = $6.00

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A

12

13

B

G

F

OriginalEquilibrium

NewEquilibrium

Both hamburgers and tacos are normal goods as budget increased from $5 to $6/weekNormal goods are goods

whose demand increases with higher budget (income) and decreases with lower budget (income)

Effect of an Income Change

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Budget Line KJ: Income = $5.00Budget Line GF: Income = $6.00Budget Line ED: Income = $8.00

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A

12

13

B

G

F

Tacos become an inferior good when budget (income) increased to $8/week Inferior goods are goods whose

demand ↓ with ↑ in the budget and ↑ with ↓ in the budget

1415

16

C

E

D

Effect of an Income Change

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A

12

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C

D

We can plot demand levels under alternative budgets (income) Referred to as an Engel

Curve

Hamburger Engel Curve Tacos Engel Curve

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Typical shape of a normal good’s Engel curve over all income levels

Typical shape of a normal good’s Engel curve over all income levels

Example of an Engel curve for a good that is an inferior good at higher income (budget) levels

Example of an Engel curve for a good that is an inferior good at higher income (budget) levels23

Effect of an Income Change

Measurement andInterpretation ofMarket Demand

24

Concept of Market DemandThe above model of consumer

behavior focused on a single individual

We can extend the above model to one where we refer to overall or total market demand for a city, county, state, country, etc.

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The market demand curve for a good is the horizontal summation of demand schedules for all the consumers in the particular market

In the above example with PH = $1.50Paula purchases 2 hamburgers/week while Beth purchases 1 hamburger→ market demand = 3 hamburgers @ a price $1.50/hamburger

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Concept of Market Demand

Notice thekink @ $2

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Demand Curve DescriptionWhen discussing events in the market place

economists use specific terms to distinguish between movement along a demand curve vs. a shift in a demand curve

Movement along a demand curve referred to as a change in quantity demanded Only 1 demand curve, just a different point on it

Alternatively a shift in the demand curve referred to as a change in demandNeed not be a parallel shift in the demand curve

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Movement from point A to C is referred to as a change in demand

Movement from point A to C is referred to as a change in demand

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Movement from point A to B is called a change in quantity demanded

Movement from point A to B is called a change in quantity demanded

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Demand Curve DescriptionReasons for a change in a demand curve

Change in household incomeChange in population characteristics

Number of children Change in marital status Household composition Price of substitutes

Change in anything other then own-price

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Concept of Consumer SurplusA characteristic of market demand

curve Concept of consumer surplus (CS) or

economic well-being CS is derived from consumption and the

fact we have a negatively sloped demand curve (with respect to its own-price)

A demand curve reveals the willingness of consumers to pay a certain price for a particular quantity of a good

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Concept of Consumer SurplusAs we showed earlier, consumers are

willing to pay a higher price for a lesser quantity

Actually do not have to pay the higher price given the level of supply coming into the market

→ Consumers realize a savingsPage 63-64

$/unit

Q

A

Q1Q2

P1

BP2

P2 > P1

Q2 < Q1

31

Why do consumerswant to pay less/unitwhen consuming more?

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Quantifying Consumer Surplus

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7 8 9 10 110

AC

B

ED

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Area ABC is the consumer surplus when market price is $6. Demand curve implies consumers are

willing to pay $10 for the 1st unit, $9 for the 2nd unit, etc.

Only had to pay $6 each for all 5 units

Area DACE is the gain in consumer surplus if the price falls to $5

Area DACE is the gain in consumer surplus if the price falls to $5

Q

$

33 Page 63

Quantifying Consumer Surplus

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7 8 9 10 110

A C

B

ED

The level of consumersurplus with a linear demand curve is [(Height × Length)/2] =([$11-$6]×5)/2=$12.50

The level of consumersurplus with a linear demand curve is [(Height × Length)/2] =([$11-$6]×5)/2=$12.50

Q

$

HeightAgain, why do wehave a consumersurplus?

In SummaryConsumer equilibrium for an

individual for a given price and budgetIndividual consumer’s demand

scheduleMarket demand curveEngel curvesChange in demand vs. change in

quantity demandedConsumer surplus

Chapter 5 examines the concept of an elasticity, one of the most important concepts in all of economics….