Consumer choice and demand decisions continued

1
Lecture 5

• Consumer choice and demand decisions continued

2
Recapitulation

• The principal behavioral postulate is that a
  decision maker chooses its most preferred
  alternative from those available to it.
• The available choices constitute the choice set.
• How is the most preferred bundle in the choice
  set located?

3
Recapitulation
x2
More preferredbundles
Affordablebundles
x1
4
Recapitulation
x2
(x1,x2) is the mostpreferred affordablebundle.
x2
x1
x1
5
Recapitulation
x2
(x1,x2) is interior .The slope of the
indiff.curve at (x1,x2) equals the slope of
the budget constraint, or MRS-p1/p2 i.e.
MU1/MU2 -p1/p2
x2
x1
x1
6
Comparative static analysis

• How does x1(p1,p2,m) change as p1 changes,
  holding p2 and m constant?
• Suppose only p1 increases, from p1 to p1 and
  then to p1.

7

Own-Price Changes
x2
Fixed p2 and m.
p1x1 p2x2 m
p1 p1
x1
8
Own-Price Changes
x2
Fixed p2 and m.
p1x1 p2x2 m
p1 p1
p1 p1
x1
9
Own-Price Changes
x2
Fixed p2 and m.
p1x1 p2x2 m
p1 p1
p1p1
p1 p1
x1
10
p1
Fixed p2 and m.
x2
p1
x1(p1)
x1
x1
x1(p1)
11
p1
Fixed p2 and m.
x2
p1
p1
x1(p1)
x1
x1(p1)
x1(p1)
x1
x1(p1)
12
p1
Own-Price Changes
Ordinarydemand curvefor commodity 1
Fixed p2 and m.
p1
x2
p1
p1
x1(p1)
x1(p1)
x1
x1(p1)
x1(p1)
x1(p1)
x1
x1(p1)
13
p1
Own-Price Changes
Fixed p2 and m.
p1
Ordinarydemand curvefor commodity 1
x2
p1
p1 price offer curve
p1
x1(p1)
x1(p1)
x1
x1(p1)
x1(p1)
x1(p1)
x1
x1(p1)
14
Own-Price Changes

• The curve containing all the utility-maximizing
  bundles traced out as p1 changes, with p2 and y
  constant, is the p1- price offer curve.
• The plot of the x1-coordinate of the p1- price
  offer curve against p1 is the ordinary demand
  curve for commodity 1.

15
Income Changes
Fixed p1 and p2.
m lt m lt m
x2
x2
x2
x1
x1
x1
16
Income Changes
Fixed p1 and p2.
m lt m lt m
Incomeoffer curve
m
x2
m
Engelcurve good 1
x2
m
x2
m
x1
x1
x1
x1
x1
x1
x1
17
Income Effects

• A good for which quantity demanded rises with
  income is called normal.
• Therefore a normal goods Engel curve is
  positively sloped.

18
Income Effects

• A good for which quantity demanded falls as
  income increases is called income inferior.
• Therefore an income inferior goods Engel curve
  is negatively sloped.

19
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
x1
20
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
x1
21
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
x1
22
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
x1
23
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
x1
24
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
Incomeoffer curve
x1
25
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
x2
m
Engel curvefor good 1
x1
x1
26
Income Changes Good 2 Is Normal, Good 1 Becomes
Income Inferior
m
x2
Engel curvefor good 2
x2
m
Engel curvefor good 1
x1
x1
27
Ordinary Goods

• A good is called ordinary if the quantity
  demanded of it always increases as its own price
  decreases.

28
Ordinary Goods
Fixed p2 and m.
x2
x1
29
Ordinary Goods
Fixed p2 and m.
x2
p1 price offer curve
x1
30
Ordinary Goods
Fixed p2 and m.
Downward-sloping demand curve
x2
p1
p1 price offer curve
Û
Good 1 isordinary
x1
x1
31
Giffen Goods

• If, for some values of its own price, the
  quantity demanded of a good rises as its
  own-price increases then the good is called
  Giffen.

32
Ordinary Goods
Fixed p2 and m.
x2
x1
33
Ordinary Goods
Fixed p2 and m.
x2
p1 price offer curve
x1
34
Ordinary Goods
Demand curve has a positively
sloped part
Fixed p2 and m.
x2
p1
p1 price offer curve
Û
Good 1 isGiffen
x1
x1
35
Effects of a Price Change

• What happens when a commoditys price decreases?
• Substitution effect the commodity is relatively
  cheaper, so consumers substitute it for now
  relatively more expensive other commodities.

36
Effects of a Price Change

• Income effect the consumers budget of m can
  purchase more than before, as if the consumers
  income rose, with consequent income effects on
  quantities demanded.

37
Effects of a Price Change
Consumers budget is m.
x2
Original choice
x1
38
Effects of a Price Change
Consumers budget is m.
x2
Lower price for commodity 1 pivots the constraint
outwards.
x1
39
Effects of a Price Change
Consumers budget is m.
x2
Lower price for commodity 1 pivots the constraint
outwards.
Now only m are needed to buy the original
bundle at the new prices, as if the
consumers income has increased
by m - m.
x1
40
Effects of a Price Change

• Changes to quantities demanded due to this
  extra income are the income effect of the price
  change.

41
Effects of a Price Change

• Slutsky discovered that changes to demand from a
  price change are always the sum of a pure
  substitution effect and an income effect.

42
Pure Substitution Effect

• Slutsky isolated the change in demand due only to
  the change in relative prices by asking What is
  the change in demand when the consumers income
  is adjusted so that, at the new prices, she can
  only just buy the original bundle?

43
Pure Substitution Effect Only
x2
x2
x1
x1
44
Pure Substitution Effect Only
x2
x2
x1
x1
45
Pure Substitution Effect Only
x2
x2
x1
x1
46
Pure Substitution Effect Only
x2
x2
x2
x1
x1
x1
47
Pure Substitution Effect Only
x2
x2
x2
x1
x1
x1
48
Pure Substitution Effect Only
x2
Lower p1 makes good 1 relativelycheaper and
causes a substitutionfrom good 2 to good 1.
x2
x2
x1
x1
x1
49
Pure Substitution Effect Only
x2
Lower p1 makes good 1 relativelycheaper and
causes a substitutionfrom good 2 to good 1.
(x1,x2) ? (x1,x2) is the
pure substitution effect.
x2
x2
x1
x1
x1
50
And Now The Income Effect
x2
(x1,x2)
x2
x2
x1
x1
x1
51
And Now The Income Effect
x2
The income effect is (x1,x2) ?
(x1,x2).
(x1,x2)
x2
x2
x1
x1
x1
52
The Overall Change in Demand
The change to demand due to lower p1 is the sum
of the income and substitution effects,
(x1,x2) ? (x1,x2).
x2
(x1,x2)
x2
x2
x1
x1
x1
53
Slutskys Effects for Normal Goods

• Most goods are normal (i.e. demand increases with
  income).
• The substitution and income effects reinforce
  each other when a normal goods own price changes.

54
Slutskys Effects for Normal Goods
x2
Good 1 is normal becausehigher income
increasesdemand
(x1,x2)
x2
x2
x1
x1
x1
55
Slutskys Effects for Normal Goods
x2
Good 1 is normal becausehigher income
increasesdemand, so the income
and substitution
effects reinforce each
other.
(x1,x2)
x2
x2
x1
x1
x1
56
Slutskys Effects for Normal Goods

• Since both the substitution and income effects
  increase demand when own-price falls, a normal
  goods ordinary demand curve slopes down.
• The Law of Downward-Sloping Demand therefore
  always applies to normal goods.

57
Slutskys Effects for Income-Inferior Goods

• Some goods are income-inferior (i.e. demand is
  reduced by higher income).
• The substitution and income effects oppose each
  other when an income-inferior goods own price
  changes.

58
Slutskys Effects for Income-Inferior Goods
x2
x2
x1
x1
59
Slutskys Effects for Income-Inferior Goods
x2
x2
x1
x1
60
Slutskys Effects for Income-Inferior Goods
x2
x2
x1
x1
61
Slutskys Effects for Income-Inferior Goods
x2
x2
x2
x1
x1
x1
62
Slutskys Effects for Income-Inferior Goods
x2
The pure substitution effect is as fora normal
good. But, .
x2
x2
x1
x1
x1
63
Slutskys Effects for Income-Inferior Goods
The pure substitution effect is as for a normal
good. But, the income effect is in the
opposite direction.
x2
(x1,x2)
x2
x2
x1
x1
x1
64
Slutskys Effects for Income-Inferior Goods
The pure substitution effect is as for a normal
good. But, the income effect is in the
opposite direction. Good 1 is
income-inferior
because an
increase to income
causes demand to
fall.
x2
(x1,x2)
x2
x2
x1
x1
x1
65
Slutskys Effects for Income-Inferior Goods
x2
The overall changes to demand arethe sums of the
substitution and
income effects.
(x1,x2)
x2
x2
x1
x1
x1
66
Giffen Goods

• In rare cases of extreme income-inferiority, the
  income effect may be larger in size than the
  substitution effect, causing quantity demanded to
  fall as own-price rises.
• Such goods are Giffen goods.

67
Slutskys Effects for Giffen Goods
x2
A decrease in p1 causes quantity demanded of
good 1 to fall.
x2
x2
x2
x1
x1
x1
x1
Substitution effect
Income effect