1 Economics of Demand or Theory of Consumer Behavior Chapter 2 Chapter 5 p. 119-120 Topics Topics • Where are we going? • Utility Theory – Marginal utility • Indifference curves • Budget constraint • Consumer equilibrium - The law of demand • Change in quantity demanded vs. change in demand • Shifters of demand • Consumer surplus Market Market Q* Quantity Supply Demand Price P*
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1
Economics of Demand
or
Theory of Consumer
Behavior
Chapter 2
Chapter 5 p. 119-120
Topics Topics
• Where are we going?
• Utility Theory
– Marginal utility
• Indifference curves
• Budget constraint
• Consumer equilibrium - The law of demand
• Change in quantity demanded vs. change in demand
• Shifters of demand
• Consumer surplus
Market Market
Q*
Quantity
Supply
Demand
Price
P*
2
What is Utility? What is Utility?
• Jeremy Bentham Introduction to the
Principles of Morals and Legislation 1789
– “Nature has placed mankind under the
governance of two sovereign masters, pain and
pleasure” … mankind “only object is to seek
pleasure and shun pain.”
• Utils
Who is Jeremy Bentham? Who is Jeremy Bentham?
• Jeremy Bentham
1748 -1832
• Philosopher
• Corresponded with
Adam Smith
• Auto-icon
Visit Jeremy at
http://www.ucl.ac.uk/museums/jeremy-bentham/visit
William Stanley Jevons 1835-1882 William Stanley Jevons 1835-1882
• Point where utility is maximized subject to the budget constraint occurs at
MUCorn MUsteak
Pcorn Psteak
• In other words, the marginal utility derived from the last dollar spent on each good is identical. This can be expanded to include all goods and services purchased by the consumer.
Consumer Equilibrium
=
14
Question What point maximizes utility?
A, B, C, or D
Why?
Question What point maximizes utility?
A, B, C, or D
Why?
Another Example - Consumer Equilibrium Another Example - Consumer Equilibrium
Points B and D
exceed the budget
Points B and D
exceed the budget
Consumer Equilibrium Consumer Equilibrium
Point C does
not maximize
utility…
Point C does
not maximize
utility…
Consumer Equilibrium Consumer Equilibrium
15
Point A maximizes
utility…
Point A maximizes
utility…
Consumer Equilibrium Consumer Equilibrium
Corn Price Change Effect
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Original Price = $20 / doz.
Consumption bundle
2.5 steak and
5 dozen ears of corn
What if price decreases to $15?
What happens to budget constraint?
Corn Price Now $15 / doz
New x-intercept
Same Why
New x-intercept
= 200 / 15= 13.2
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8 9
1
0 1
1
New equilibrium
= 2.75 steak and 6 corn
Why an increase in corn
and increase in steak?
16
Income / Substitution Effects
1 2 3 4 5 6 7 8 9 10 11 12 13
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
1
2
3
4
5
6
• Substitution Effect – relative prices
MUCorn / Pcorn = MUsteak / Psteak
• Real Income Effect – market opportunity set
Corn Price Now $50 / doz
New y-intercept same
Why?
New x-intercept
= 200 / 50 = 4
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4 5
6
7
8 9
1
0 1
1
New equilibrium
= 3.125 steak and 1.5 corn
Why an decrease in corn
and increase in steak?
Price Consumption Curve
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4 5
6
7
8 9
1
0 1
1
• Indicates the response of the rational consumer
to changes in price of corn alone,
income and price of steak being held fixed.
• Arrow indicates increase utility!
• Negative slope – at lower price consumes
more corn but less steak as price of corn drops
• Positive slope – at higher price consumes more of
both as corn price drops
17
Individual Demand Curve - Corn
Demand Curve for Corn
0
10
20
30
40
50
60
0 2 4 6 8
Quantity
dozen ears of corn
Pri
ce
do
llar
per
do
zen
ears̀
Demand Schedule
Price Quantity
50 1.5
20 5
15 6
Person 1 Person 2 Market
Price Quantity Quantity Quantity
50 1.5 3 4.5
20 5 6 11
15 6 7 13
Market Demand Curve - Corn
The market demand curve is the horizontal
summation of the demand schedules
for all the consumers in the market.
At a price of $50, Person 1 would buy 1.5 dozen
ears of corn while Person 2 would buy 3.
Therefore, the market demand is equal to 4.5
dozen ears at a price of $50.
The market demand curve is the horizontal
summation of the demand schedules
for all the consumers in the market.
At a price of $50, Person 1 would buy 1.5 dozen
ears of corn while Person 2 would buy 3.
Therefore, the market demand is equal to 4.5
dozen ears at a price of $50.
+ =
Market Demand Curve - Corn
Person 1
0
10
20
30
40
50
60
0 5 10
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
Person 2
0
10
20
30
40
50
60
0 5 10
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
Market
0
10
20
30
40
50
60
0 5 10 15
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
18
Demand Curve Jargon
• Specific terms to distinguish between
movement along a demand curve and a shift
in a demand curve
• Change in the quantity demanded is a
movement along a demand curve - Cause
• Change in demand is a shift in the demand
curve - Causes
Movement Examples - Know
• Movement A to B is ?
• Movement A to C is ?
• Movement B to C is ?
• Movement C to A is ?
A B
C
Quantity
Pri
ce
Consumer Surplus
• The demand curve reveals the maximum willingness of
consumers to pay for a corresponding quantity
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
What is the consumer’s
WTP for the 2nd unit?
What surplus does the
consumer receive if
price = $ 6?
19
Consumer Surplus
• What is WTP for the 4th unit? Surplus = ?
• What is WTP for the 6th unit? 8th ? 10th? Surplus = ?
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
What is surplus
at the 14th unit?
Why?
Consumer Surplus
• Sum of surplus at each quantity
• Triangle – below the demand curve and above the price line
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
Consumer Surplus Change
• Triangle area given by points ABC =
consumer surplus at a price = $ 6
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
A
B C
20
Consumer Surplus Change
• What is the change in consumer surplus if price increases to $8?
• Consumer surplus is now triangle ADE lose of area DEBC
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
A
B C
E D
Consumer Surplus
• Calculating the area = (height x width)/2
• = {(11-6) x (10-0)}/2 = 25 utils
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
Individual Demand Curve - Steak
• Be sure to be able to do the mechanics for
steaks
– Consumer equilibrium
– Change in steak prices holding income and
price fixed – substitution / income effect
– Price consumption path
– Individual demand curve
21
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
`
• Original Consumer Equilibrium
5 corn and 2.5 steak
• Income doubles
What happens?
Income Change Effect
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
New y-intercept = 400 / 40 = 10
Income Doubles
New x-intercept
= 400 / 20 =20
New consumer equilibrium
9 corn and 5.5 steak
9*20+5.5*40 =400
Why an increase in both
corn and steak?
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
New x-intercept
= 100 / 20 = 5
New y-intercept = 100 / 40 = 2.5
New consumer equilibrium
2 corn and 1.5 steak
2*20+1.5*40 = 100
Why a decrease in both
corn and steak?
Income Halves
22
Income Expansion Path
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
• Indicates the response of the rational consumer
to changes in income alone, prices of steak and
corn being held fixed.
• Arrow indicates increase utility!
• Positive slope – both goods normal goods
• Negative slope – one good is an inferior good
What type of goods
are steak and corn?
0
50
100
150
200
250
300
350
400
450
0 1 2 3 4 5 6
Pounds of Steak
Inc
om
e
Engel Curve
Steaks – normal or inferior good? Income and Steaks