Consumer Demand Theory - Analysis

This week, we put the two together to analyze the problem of consumer choice In particular, we examine how price and income changes affect consumer choice by looking at the income and substitution effects The effects give greater insight into determinants of consumer demand. We use income and substitution effects to construct an individual consumer’s demand curve We then construct the market demand curve from an individual consumer’s demand curve Finally, we use the income and substitution effects to understand the relationship between wages and hours of work in the labour market.

What is the consumer optimisation problem? Use the example of cinema tickets and bowling. 

The consumer has infinte wants and limited resources. Model created to show how she can maximise expenditure - the model has two goods (cinema tickets and bowling) with no role for saving or borrowing. The consumer problem is to maximise well being subject to constraints (income and prices which are observable). We cannot predict how the consumer will allocate expenditure between two goods, so a complete mapping must be done of consumer’s tastes. 

What is the marginal rate of substitution?

Where the marginal rate of substitution (MRS) is the quantity of a good that must be sacrificed by the consumer to increase the quantity of another good by one unit without changing total utility

Consumer chooses the consumption bundle where the MRS is equal to relative prices.

Define a normal good

When income increases consumption increases.

Define inferior goods

Consumption falls when income increases (cheap goods like pasta)

Name and define the two effects of a decrease in the price of a good

-Income effect (holding prices constant): can afford to reach higher well being so want to consume more of everything (if both goods are normal)

-Substitution effect (holding real income constant): cheaper to get well being from good so move from more expensive good to cheaper good.

Describe the application of the income and substitution effects of the labour market, using the example of the work-leisure trade off

Assume individuals face a choice between work and leisure. Opportunity cost of leisure is the money value of foregone consumption. An increase in wage rate either has a substitution effect (if the wage rate increases the opportunity cost of leisure increases, leading to a decrease in the number of hours of lesireu), or income ffect (increase in real wage rate leads to more disposable income, whih can lead to more money and therefore more hours being spent on leisure, since leisure is a normal good). Whether the number of hours of leisure increases or decreases depends on whether the income effect dominates the substitution effect.