Econ 201 Lecture 4.1 Consumer Demand. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-2 Budget Line We represent the consumption opportunities.

Econ 201 Lecture 4.1Consumer Demand

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-2

Budget Line

• We represent the consumption opportunities available to the consumer with a budget line. Shows the combinations of goods and

services consumers are able to consume, given income and prices


Figure 7.1 The Budget Line


Budget Line Characteristics

• Each point on the budget line represents consumption bundles of goods that can be purchased at current prices with a given amount of income.

• The budget line is a straight line with a negative slope: Slope of the budget line = Represents the trade-offs between

the goods

Px Py


Budget Line Characteristics (cont’d)

• The intercepts of the budget line represent the maximum amounts of the goods that the consumer can buy. Found by dividing income by the price of

each good

• Consumption bundles outside the budget line cannot be purchased with the given income.


Figure 7.2(a) The Effect of Changes in Income and Price on the Budget Line


Figure 7.2(b) The Effect of Changes in Income and Price on the Budget Line


Assumptions about Consumer Behavior

• Consumers maximize their well-being, not their income. Doesn’t rule out altruism

Economists use the term utility to refer to the benefits consumers receive from consuming goods and services.


Assumptions about Consumer Behavior (cont’d)

• Consumers are rational. They behave in a consistent manner.

• Consumers have perfect foresight about the satisfaction they will receive from a good or service.


Marginal Utility

• Consumers make decisions based on the additional benefit from consuming one more unit of a good or service. Marginal Utility (MU)—the change in

total utility that results from a one unit change in consumption.


Maximizing Utility

• Consumers’ objective is to maximize their utility, given the fact that their income is limited.

• Consumers do this by comparing the marginal utility of one good to the amount of another good they must give up to get it.


Marginal Utility per Dollar

• The first step in analyzing consumer behavior is to calculate the marginal utility a consumer receives from each dollar spent on a good or service. For example:

per Dollar of PizzaMarginal Utility Marginal Utility of Pizza

Price of Pizza


Utility Maximization

• Consumers maximize their utility by allocating their income to the good that yields the highest MU per dollar.


Utility Maximization (cont’d)

• For example, suppose a consumer purchased two goods, CDs and Pizza:

If MUcd / Pcd > MUpizza / Ppizza then the consumer should buy more CDs.

If MUpizza / Ppizza > MUcd / Pcd then the consumer should buy more pizzas.


The Equimarginal Principle

• Thus, utility is maximized when the marginal utility per dollar is equal across all goods. The consumer is in equilibrium.


Utility Maximization and Individual Demand

• Downward-sloping individual demand curves result from consumers maximizing their utility subject to their budget constraint.


Income and Substitution Effects

• A change in the price of a good leads to two effects: The substitution effect—consumers

will purchase more a good that has become relatively cheaper.

The income effect—a change in the price of a good changes a consumer’s purchasing power.


Income and Substitution Effects (cont’d)

• For normal goods, the income effect reinforces the substitution effect.

• For inferior goods, the income effect partially offsets the substitution effect.


Summary

• All consumers make decisions by allocating their limited income over the goods and services they would like to consume.

• Consumers maximize utility, are rational, and have perfect foresight.


Summary (cont’d)

• Consumers will allocate their income such that marginal utility per dollar spent is equal across goods.

• Other things remaining constant, consumers will alter their purchases of a good when the price of that good changes. Individual demand is the result of

utility maximization.

Econ 201 Lecture 4.1 Consumer Demand. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-2 Budget Line We represent the consumption opportunities.

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