Part 4 The Theory of Demand • We have drawn all our demand curves downward sloping • Why do economists think demand curves normally slope downward? • Market demand curves are aggregations of individual (or household) demand curves • What factors will affect a household’s demand for a good?
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Part 4 The Theory of Demand We have drawn all our demand curves downward sloping Why do economists think demand curves normally slope downward? Market.
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Part 4The Theory of Demand
• We have drawn all our demand curves downward sloping
• Why do economists think demand curves normally slope downward?
• Market demand curves are aggregations of individual (or household) demand curves
• What factors will affect a household’s demand for a good?
Household Consumption Choices
• Households buy a variety of goods (a “bundle” of goods)
• Different households buy different bundles of goods
• Household choice will depend on:- income- relative prices of goods- preferences
• Income and prices can be shown in a budget constraint
• What shapes preferences?• How can a given set of preferences be
represented?
Budget Constraint
Qy
Qx
Affordable
Unaffordable
Budget constraint with given income = Iand given prices Px and Py:I = PxQx + PyQy
Preferences and Utility
• Which of the affordable combinations will a household choose to purchase?
• The intuitive answer is that the household will choose the bundle of goods that it “likes the best” or provides the most satisfaction of all the affordable bundles
• More formally, if the degree of satisfaction of all wants and desires can be measured on a single “utility” scale, the household will choose the bundle of goods that maximizes utility
Cardinal Utility Theory
• When the idea of a utility measure was first proposed in economics it was sometimes assumed that one could think of units of utility in the same way as units of weight or temperature
• Such a measure has a defined unit that can be added, multiplied, & etc
• Many possible units of measure but they are all linear transformations of each other (eg: deg F = 32 + 9/5 C)
Total and Marginal Utility
• More goods give more total utility• More of any particular good will
tend to give less additional total utility with each increment
• Diminishing marginal utility• Diminishing marginal utility and the
“paradox of value”• What is the rule for maximizing total
utility out of a given budget when each good has diminishing marginal utility?
Maximizing Utility
Quantity MUx MUy
1 20 16
2 18 15
3 14 14
4 8 13
5 0 12
Example of two goods x and y
Utility maximizing bundle with an incomeOf $6 and Px and Py= $1?Utility maximizing bundle with an income$16 and Px=$3 and Py=$2
Maximizing Utility
• The total utility gained from a given budget will be maximized where the budget is all spent and marginal utility per dollar spent is equalized across all goods
• Rules for a utility maximum:
I=PxQx+PyQy and
MUx/Px = MUy/Py or
MUx/MUy = Px/Py
Implications
• Maximization is where
I=PxQx+PyQy and
MUx/Px = MUy/Py
• Fall in Px will increase ability to purchase X and Y. If X is normal Qx increases.
• Fall in Px leads to a substitution of X for Y
• Increase in Qx decreases MUx
• Decrease in Qy increases MUy
Individual and Market Demand
• Market demand curves are the horizontal summation of the demand curves of all individuals or households
Ordinal Utility Theory
• The idea of utility as measurable in a cardinal way was subject to much criticism
• The idea of a utility measure as a rank ordering replaced the idea of cardinal measurement
• An “ordinal” measure is a ranking only.
• No unit of measurement• Higher numbers imply only
more preferred
Preferences
Qy
Qx
DefinitelyLess preferred
to A: U<5
DefinitelyPreferred to
A: U>5
Bundle A: X’,Y’U=5
If both X and Y provide utility
X’
Y’
Indifference Curves
A locus of all bundles with the sameutility ranking. The consumer is indifferentbetween them
U=5
U>5 (preferred toAny point on U=5)
U<5(any point on U=5 preferred)
Indifferent between any point on U=5Qy
Qx
A Preference Map
U=5
U=6
Qy
Qx
a
b
c
d
Preference Maps
• In order to draw a preference map at all we are assuming:
• goods are infinitely divisible (indifference curves are continuous)
• Every combination of goods can be ranked (preferences are complete)
• Preferences are consistent (indifference curve cannot intersect or touch)
The Shape of Indifference curves
• Negative slope (more is preferred to less)
• Marginal rate of substitution (MRS)
• Convex to the origin (diminishing marginal rate of substitution)
• MRS=ΔQy/ΔQx keeping utility constant—slope of the indifference curve
Maximizing Utility Once Again
• In the ordinal utility context maximizing utility means choosing that bundle of goods that is on the highest indifference curve achievable with given income and prices
• Budget line: I = PyQy+PxQx
PyQy = I- PxQx
Qy = I/Py – (Px/Py)Qx
I/Py is the Y intercept
Px/Py is the slope of the budget line
Budget line
I/Px Qx
Qy
I/Py
I = PyQy+PxQx
Px/Py is the slope of the budget line
Utility Maximization:Indifference Curves
U=5
Qx
Qy
Qy*
Qx*
Highest indifference curveachievable
U=4
U=6
Budget line and indifference curve are tangent.On budget line and highest indifference curvewhere MRS=Px/Py
Changes in Income
• Changes in income with constant prices will shift the budget line outwards in a parallel fashion
• Normal goods will show increased consumption with higher income
• Inferior goods will show decreased consumption with higher income
• Consumer preferences determine if a good is normal or inferior (shape of indifference curves)
Income Effect
Qy
QxQx’ Qx”
U”
U’
I’
I”
Income consumption line
X and Y normal
Qy
Qx
I”I’
U’
U”
Qx” Qx’
X inferior, Y normal
Changes in Price
• Change in the price of X changes the slope of the budget line by changing the X intercept
Qy
QxI/Px’ I/Px”
Px’>Px”I/Py
Price Effect and Demand Curves
Qy
Qx
Qx
Px
U’
U”
Qx’ Qx”
Qx’ Qx”
Budget linewith Px”
Px”
Budget linewith Px’
Px’
Demand curve for X
Income and Substitution Effects of a Price
Change• The effect of a price change on
the demand for a good can be decomposed into two effects
• The substitution effect is the effect of the change in relative prices keeping real income (utility) constant
• The income effect is the effect on real purchasing power of the price change
Income and Substitution Effects of a Price
ChangeQy
QxQx’ Qxs Qx”
Sub Inc
a b
s
Overall effect (a to b) can be broken down into a substitutionand income effect
Income and Substitution Effects of a Price
Change• Income effects of a price change are
usually small--unless the good accounts for a high proportion of expenditure
• For normal goods the income effect works to reinforce substitution effect and a price decline must increase quantity demanded
• For inferior goods the income effect works against the substitution effect, but the substitution effect is usually larger
Income and Substitution Effects of a Price
Change• What does it take to get an
upward sloping demand curve? The “Giffen” good case
• Giffen goods must be both inferior and important in the budget
• Very unlikely to come across a Giffen good
• Policy uses of income and substitution effects--carbon taxes and income tax rebates