Part 4: Consumer behaivour

Consumer equilibrium,Deriving the DC, Income& Substituion effects

What is consumer equilibrium and how can consumers do this with reference to the curves

We have one of what? and multiple of what?

• The consumer’s goal is to make themselves as happy as they can, within the constraints of what they can afford.

• Trying to reach the HIGHEST indifference curve, subject to their budget constraint

• One budget line and multiple IC’s, the BUNDLE that touches the BL is the equilibrium

What does Optimal bundle choice mean

-Tangency

-MRS=

-Occurs when

• IC tangent to BL, SLOPES are equal at this point

• MRS=MRT

• Consumer is willing to trade between Good A and B at the same ratio the Market forces them to trade (trade at rate of Oppo. cost)

True/ False:

MRT is consumer based and MRS is market based

False

The other way around

How would Consumers maximise utility cardinally and how can we rearrange this so that its MRS= MRT

• MUx/Px=MUy/Py

Deriving the Demand curve

• We have the budget line 10x+5 Y=100

• Sub in 6(given) to get y=8

• Demand curve: The price is given as R10 and we know at equilibirum the consumer buys 6 units

• When price changes to 20 (given),the units consumed is 2 (given)

• Sub in 2 into the new budget line 20x+5y=100 and you get the 12

What’s the:

• Substitution effect

• Income effect

• The relative price of good X and good Y has

  changed. So, you may choose to substitute

  between the goods now that one may look

  relatively cheaper/more expensive

• This effect says that because of the change in

  relative prices, your real income has changed. As

  a result, you may choose to adjust how much of

  each good you purchase

Real income vs nominal income

• Nominal income: The actual amount of money you have (here, M=100).

• Real income: The purchasing power of that money — i.e., how many goods and services you can buy with it, given current prices.

• (Purchasing power and real income)

(When the price of Good X rises from 10 to 20:

• Your nominal income hasn’t changed (still 100).

• But your real income falls, because that same 100 now buys fewer units of X than before.)

Which effect do the following questions fall under:

• Under the new relative prices, which consumption bundle would I substitute for, so that I have the same level of utility as before?

• How does my consumption of the goods change if I were to change my income, without varying the prices of goods X and Y?

Substitution effect

Income effect

What type of movements does the substitution effect and income effect cause and where do they move

• movement along the same indifference curve

• parallel shift of my budget line

How should the hypothetical budget line look when working out income and substitution effects,2 important points

• Have new relative price ratio (i.e., be parallel to our new budget line)

• Be tangent to our original indifference curve

• Add point C (point of tangency)

What is the Total Effect

What is it made of

(btw Px decreased in this example)

We say the total effect on consumption is the shift from A to B.

Income and Substitution effect (vector arrows)

Explain this graph in terms of the two effects

• ADDING ON* :A and C are both on the same utility curve.Substitution effect means utility must be the same

What happened to price X now

Px increased

How do we know this is an example of inferior goods(HINT:Purple arrows)

• Look at the Income Effect

arrows now (purple arrows)

• For good Y, when real income decreased, consumption of good Y decreased (this is a normal good).

• For good X, when real income decreased, consumption of good X increased.

• This is the characteristic of an inferior good.

Imagine a price change in good x

NORMAL GOODS

• When price changes, the____ always goes opposite to the price change.

• The _______ works in the same direction as the substitution effect.

• So both effects reinforce each other.

• substitution effect

• income effect

Imagine a price change in good x

INFERIOR GOODS

• The substitution effect still goes____ to the price change.

• But the income effect goes in the ____ direction to the substitution effect.

• Substitution effect is stronger, so it dominates the income effect.

-What does second point mean

• opposite

• opposite

• Opposite direction means substitution says ‘buy more,’ while income says ‘buy less.’

What is the paradox of value(it asks what questions,using which 2 resources) ,who invented it

• Adam smith

• Why is water cheap and diamonds expensive?

• Water is very useful – it supports all life on Earth.

• Diamonds are largely useless

What is the Basic idea of the Paradox of value and explain using diamond-water paradox

Basic idea is to consider the marginal utility of the products not

their total utility

The paradox

• Water: essential for life, huge total utility, but very cheap.

• Diamonds: not essential, small total utility, but very expensive.

• Why? Because prices reflect marginal utility, not total utility.

Explanation

• Total utility: Water gives enormous satisfaction overall (we need it daily).

• Marginal utility: Each extra unit of water adds very little satisfaction (the 100th glass doesn’t matter much).

• Diamonds: Total utility is small (not life‑saving), but each extra unit adds a lot of satisfaction because they’re rare.

• So the marginal utility of diamonds is high, while the marginal utility of water is low.

• Prices are determined by marginal utility → diamonds are expensive, water is cheap.

• Marginal utility can be modelled by a .

• Total utility can be modelled by

Demand curve

-Demand is about how much extra satisfaction (marginal utility) you get from each additional unit.

• As marginal utility falls with more consumption, willingness to pay falls → this shapes the downward‑sloping demand curve.

Consumer surplus

How to read this graph? How is MU low when quantity demanded is is high for left graph

Explain right graph

• High quantity demanded at low price → means people consume a lot of water overall. That’s why the shaded area (total utility) is huge.

• Marginal utility is low → because once you already have plenty of water, each extra unit adds very little satisfaction.

• On the graph:

  • The demand curve itself represents marginal utility (willingness to pay for one more unit).

  • At the equilibrium point, the price of water is low, so the marginal utility of an extra unit is also low.