Chapter 5 Consumer choice and demand decisions

1. Chapter 5Consumer choice and demand decisions David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. Utility (1) Utility is a measure of happiness. However, we cannot say that one apple can make me twice as happy as one banana. So, utility is not a cardinal measure. We can easily say that I like apple more than banana. This kind of measure is called an ordinal measure.

3. Utility (2) Total utility of eating five slices of pizza is the total happiness we get from eating all pizzas. If you are talking about eating the first, second, third, etc. slices of pizza, we are talking about the marginal utility. As you consume more pizzas, the total utility increases, however, the marginal utility decreases.

4. Example QxTUx MUx 0 0 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 6 30 0 7 28 -2 The total and marginal utility of good x.

5. Why the Demand Curve is Downward Sloping • When you consume a good little, the marginal utility of the extra unit is high. Therefore, you are willing to pay a higher amount for the additional unit. • MWP is the inverse function of demand. • As you consume more, the MU decreases.

6. Optimal Consumption • The solution which gives the maximum utility is as follows: On the margin, the marginal utility per lira you get should be equal for all goods. MUX1= MUX2 Px1 Px2

7. Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximise utility

8. Four key elements in consumer choice Consumer’s income Prices of goods Consumer preferences The assumption that consumers maximise utility

9. The budget line Income and prices together determine the combinations of the goods that the consumer can afford. The slope of the budget line is the ratio of the prices. (relative price) If the income increases, the budget line shifts parallel to the right. A B G C D E F Price of meals is £5; price of films is £10. Consider a student with a budget of £50 to spend on meals and films.

10. 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. Quantity of films c a b Quantity of meals

11. 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. Preferred region Quantity of films d c a b e Dominated region Quantity of meals

12. An indifference curve 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) U2 Quantity of films U2 Quantity of meals

13. Marginal Rate of Substitution. The slope at any point on an indifference curve is the marginal rate of substitution. • It is the rate at which a consumer is willing to trade one good for another. • It is the amount of one good that a consumer requires as compensation to give up one unit of the other good. • The MRS decreases as you consume more of that good. This is called decreasing MRS.

14. 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. U3 U2 U1 Quantity of films B C U3 E U2 U1 BL Quantity of meals The point at which utility is maximised is found by bringing together the indifference curves (U) and the budget line (BL)

15. 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

16. Normal goods Films BL1 BL0 C' C U2 U1 Meals When both goods are NORMAL, an increase in income induces a new choice point at C' The quantity demanded of each good increases

17. An inferior good and a normal good BL1 Films BL0 C' U2 C U1 Meals When “meals” is an inferior good the increase in income takes the consumer from C to C' The quantity of meals falls and the quantity of films increases

18. Adjustment to a price change An increase in the price of one good shifts the budget line altering its slope which reflects relative prices.

19. An increase in the price of meals (1) Films BL0 BL1 Meals The increase in price of meals shifts the budget line from BL0 to BL1 The increase in price reduces purchasing power.

20. An increase in the price of meals (2) The consumer moves from C to E as the price of meals rises The overall effect is a reduction in quantity of meals demanded E U1 Films C U2 H BL0 BL1 Meals Tracing out more of such points at different prices enables us to identify the Demand curve.

21. 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. More Expensive: Buy less THE INCOME EFFECT is the adjustment to the change in real income. Higher income, buy more of the normal goods, buy less of the inferior goods. Total change in the consumption of the goods are determined by adding up these two effects.

22. Deriving the market demand curve If at a price of £5, consumer 1 demands 11 units Consumer 1 and consumer 2 demands 13 units Consumer 2 5 then market demand at a price of £5 will be 24 units. Market 11 13 24 The market demand curve is the horizontal sum of the individual demand curves Price Quantity