ECON201

Law of demand: Price and quantity demanded of any good and service are inversely related to each other

Shifts along demand curve caused by changes in price only

Shifts in demand curve caused by:

  • Price of substitutes
  • Price of complements
  • Income
  • Preferences
  • Number of consumers
  • Future expectations

Law of supply: Price and quantity supplied of any good and service are generally positively related to each other

Quantity and price general positive relationship due to law of diminishing marginal production leading to increasing marginal costs

Shifts along supply curve caused by changes in price only

Shifts in supply curve cause by:

  • Price of other goods
  • Production costs
  • Technology
  • Number of sellers
  • Future expectations

The magnitude of changes in equilibrium price and quantity are impacted by:

  1. Size of shift
  2. Slope of curves related to price elasticities

As you move down a demand or supply curve, it become less elastic (more inelastic) - Eventually perfectly inelastic at the horizontal axis

Market efficiency sees:

  • Both CS and PS maximised
  • DWL = 0
  • Last unit transacted MB = MC

Taxes, price ceilings and price floors create DWL and market inefficiencies

Producer subsidies create DWL but increase PS at a cost to the government

Consumer Behaviour Introduction

How do consumers make purchases?

Ultimately, consumers are assumed to ‘optimise’ their utility given scarce resources

Consumer theory is the basis for the ‘demand’ side of the supply and demand model

Consumer Preferences & The Concept of Utility

Consumers are rational and ‘optimise’ consumption decisions given scarce resources

Four assumptions about consumer preferences:

  1. Completeness and Rankability

   Consumers can compare bundles of goods and rank them based on preference

  1. For most goods, more is better than less

   Non-satiation and free disposal → MU > 0

   Preferences are strongly monotonic: A basket with more of at least one good and no less of the other good is preferred to the original basket

  1. Transitivity

   Imposes logical consistency on preferences

   Consumers make choices that are consistent with each other e.g. if A > B and B > E then A > E

  1. The more a consumer has of a particular good, the less they are willing to give up something else to get even more of that good

   This assumes consumers like variety

   Principle of diminishing marginal utility

Utility is a measure of how ‘satisfied’ consumers are

  • A measure of happiness or well-being
  • It is not a measure of consumer income

A utility function mathematically describes the relationship between a consumers actual consumption and their level of well-being

  • Represents consumer preferences
  • Can take a variety of mathematical forms
  • Haves to conform to the four assumptions about preferences

Utility with a single good

The marginal utility (MU) is the slope of the total utility function

Diminishing Marginal Utility: After some point, increased consumption of a good sees the marginal utility of that good begin to fall

As the quantity consumed increases, the marginal utility gained from consuming each additional good falls

Marginal Utility: The additional utility a consumer receives from an additional unit of a good or service

Comparing Consumption Outcomes

The ‘rules’ for utility allow only for an ordinal ranking of consumption bundles

  • An ordinal ranking implies bundles can be ranked from best to worst
  • A cardinal ranking would allow a person to determine how much better one bundle is, compared to another
    • There is no real-world measure of how much more a consumer likes the bundle of goods A to the bundle of goods B
Indifference Curves

Ordinal rankings mean we care about relative outcomes

A consumer is indifferent between bundles is when they derive the same utility level from two or more bundles

An indifference curve plots out all of the consumption bundles that provide a consumer with the same level of utility or satisfaction

Characteristics of Indifference Curves (from the four assumptions about consumer preferences):

  1. They can be drawn - completeness and rankability
  2. Curves further from the origin represent higher utility - more is better
  3. Curves never cross - transitivity
  4. Convex to the origin - consumers like variety + diminishing marginal utility

Curves are:

  • Parallel
  • Downward sloping
  • As you move down the gradient diminishes

A consumers indifference curves cannot cross

Tradeoffs: Initially consumers consume greater quantities of one good compared to another, however this can be compensated by consuming a greater amount of the latter good and a lesser amount of the first good to leave utility unchanged.

E.g. as apartment size increases, Jo is less willing to trade off the number of friends for additional apartment size → diminishing marginal returns

The Marginal Rate of Substitution (MRS)

Indifference curves describe tradeoffs

→ How much of one good are you willing to give up for one more unit of another good?

→ The slope of the indifference curve captures this tradeoff - Referred to as the marginal rate of substitution

Describes the rate at which one is willing to trade off or substitute exactly 1 unit of good X for more of good Y, and be equally well off

As you move down an indifference curve, you experience a diminishing marginal rate of substitution

Along an indifference curve, the change in utility is zero

The law of diminishing utility dictates that the higher quantity consumed of something, the less marginal utility is gained from consumption and vice versa.

Therefore, the marginal rate of substitution decreases as you move down an indifference curve

The MRS between two goods is equal to the inverse of the goods marginal utilities

  • Steeper curves imply the consumer is willing to give up a lot of Y to get one unit of X, or could trade 1 unit of X for a lot of good Y
  • Flatter curves imply the consumer would require a large increase in good X to give up one Y, or could trade 1 unit of good Y for a lot of good X

The Curvature of Indifference Curves: Substitutes and Complements

The shape of indifference curves reveals information about the relationship between products.

  • Relatively straight indifference curves - goods that are more easily substitutable for one another
    • e.g. Decaf latte for decaf coffee
  • Indifference curves that are more convex to the origin - goods that are more complementary to one another
    • e.g. tortilla chips for guacamole

Perfect substitutes: Goods that the consumer will trade at a fixed rate and receive the same level of utility (MRS is constant)

Perfect complements: Goods that the consumer must consume in a fixed proportion

e.g. Tortilla chips in 3-oz and 12-oz proportions - would be willing to trade 4 for 1 no matter the quantity so MRS is constant in this case

e.g. left and right shoes

The same consumer can have indifference curves with different shapes

Initially for low levels of utility (Ua), bananas and strawberries may be substitutes

As utility increases (Ub), consumers might prefer a variety of fruit in their diet more than initially

Consumers Income and the Budget Constraint

Could be visualised as a consumption possibility frontier - similar to PPF

The budget constraint is a curve that describes the entire set of consumption bundles a consumer can purchase when spending all of their income

It is generally plotted alongside indifference curves.

For two goods: Income = PxQx + PyQy

Gradient = -Px / Py

Factors that Affect the Budget Constraints Position

The slope and position of the budget constraint are a function of two factors: income and relative prices

  1. Change in income shifts the budget constraint by changing the intercepts - moves parallel
  2. Change in the price of one good pivots the budget constraint by changing the slope - only parallel if price change is proportionate
Consumer Optimisation Problem
  • Indifference curves - utility and describe consumer preferences
  • Budget constraint describes which bundles are feasible
    • Combining concepts allows the understanding of consumer choices

Consumers face a constrained optimisation problem → Maximise utility, subject to income and market prices

Bundle A slope of the budget line = slope of the indifference curve

Consumer equalises marginal utility per dollar spent is across all products

Getting more utility per dollar from X, therefore you should consume more of good X until the MUx decreases so that the ratio is equal again

Two consumers facing the same income and the same prices but have different preferences will still have the same MRS at their optimal bundles due to the same ratio of prices

Interior Solution: A utility maximising bundle that contains positive quantities of both goods

Depending on consumers preferences and relative prices, in some cases a consumer will not want to spend any of their money on a good

Corner solution: a utility-maximising bundle located at the ‘corner’ of the budget constraint where the consumer purchases only one of two goods

Perfect substitutes:

Perfect complements:

Indeterminate budget constraint:

Individual and Market Demand

Income Changes & Individual Consumption Choices

→ Links consumer decision framework with individual and market demand

The income effect - Change in a consumer’s consumption choices due to a change in the consumer’s income (or purchasing power), holding relative prices constant

It depends on the good whether higher income is associated with higher consumption of goods

Normal good - higher income is associated with rising consumption e.g. vacations and basketball tickets

Necessity goods: normal goods for which income elasticity is between 0 and 1 e.g. water consumption, electricity, clothing etc.

10% income increase / 3% quantity demanded increase = Ep = 0.3

Luxury goods: normal goods for which income elasticity is greater than 1 e.g. vacation homes, jewelry, expensive steaks, etc.

10% income increase / 13% quantity demanded increase = Ep = 1.3

Inferior good - higher income is associated with falling consumption e.g. lower quality goods, income rise sees switch away to higher quality goods

Income expansion path: a curve that connects a consumer’s optimal bundles at each income level

  • If both goods are normal goods, the path is positively sloped
  • If the slope of the income path is negative, one of the goods is an inferior good

Engel curve: Shows the consumption-income relationship

  • Shows the relationship between quantity of a good consumed and a consumer’s income
  • If the Engel curve has a positive slope, the good is a normal good at that income level
  • If the Engel curve has a negative slope, the good is an inferior good at that income level

Engel curve compares income to one good

Deriving demand curve:

Relates to law of demand and substitution effect (consumers swap to cheaper good as price decreases)

First part of demand curve is elastic (price drop causes greater increase in demand), second part is inelastic (price drop causes lesser increase in demand)

Area under demand curve represents consumers total utility

Income and Substitution Effects

When the price of a good changes relative to another, two things happen:

  1. One good becomes relatively more expensive, and the other relatively less
  2. The total purchasing power of a consumer’s income changes

The substitution effect refers to the change in a consumer’s consumption choice that results from a change in the relative prices of two goods

It is always negative if price is increasing- when the price of one good relative to the other increases, consumption of the former falls, and vice versa

e.g. if Px increases and Py is constant, substitute away from good x

The income effect refers to the change in a consumer’s consumption choice that results from a change in the purchasing power of the consumer’s income

This can be negative or positive depending on whether the good is inferior or normal

Total effect = substitution effect + income effect

Steps to computing substitution and income effects

  1. Draw the new budget constraint and find the optimal bundle (B)
  2. Draw a line parallel to the new budget constraint, tangent to the old indifference curve

   Find the optimal bundle on the old curve associated with this theoretical budget constraint A’

   BC’ must touch the original indifference curve whilst being parallel to BC2

  1. The substitution effect is the difference in quantities between A and A’
  2. The income effect is the difference in quantities between A’ and B

All happens simultaneously!

Income effect tells us whether the good is normal or inferior

Normal good - income effect increase

Inferior good - income effect decrease

What determines the size of the substitution and income effects?

  1. Curvature - the size of the substitution effects depends on the curvature of the indifference curves

If an indifference curve is relatively straight - 2 goods are relatively substitutable, therefore there is a larger substitution effect

  1. Quantity consumed before price change - the income effect increases with the amount spent on a good before a price change

The income effect increases with the amount spent on a good as you can get more from trading off consumption of that good

MRS = -PY / PX = MUx / MUy → (= Px / Py at budget line)

MRTS = - change in capital / change in labour = MUL / MUk → (= w / r at isocost line)

TC = rK + wL → gradient - w/r

Income = QyPy + QxPx → gradient - Px / Py