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AAEC 3315 Agricultural price Theory. Chapter 2 Consumer Behavior and Individual Demand. Objectives. To gain an understanding of: How an individual’s budget limits the goods that can be purchased About “Utility” Indifference curves and Budget lines Utility Maximization Decision

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Aaec 3315 agricultural price theory l.jpg

AAEC 3315Agricultural price Theory

Chapter 2

Consumer Behavior and Individual Demand


Objectives l.jpg
Objectives

  • To gain an understanding of:

    • How an individual’s budget limits the goods that can be purchased

    • About “Utility”

    • Indifference curves and Budget lines

    • Utility Maximization Decision

    • Derivation of the Demand Curve and the Law of Demand

    • Derivation of the Engel Curve


Consumption demand l.jpg
Consumption & Demand

  • Factors affecting the consumption decision:

    • An individual’s taste & preferences

    • How much money an individual has to spend (budget)

    • Price of the goods in the marketplace


Consumption utility l.jpg
Consumption & Utility

  • Utility – the satisfaction derived from consuming a product, good, or service

    • Since utility is derived from the inherent characteristics or qualities that make a product desirable, utility may be objective or subjective.

    • Util - a hypothetical numerical measurement of utility (used to represent the satisfaction derived from consuming products).


Total utility and marginal utility l.jpg
Total Utility and Marginal Utility

  • Total Utility (TU) – total satisfaction derived from consumption of a good.

  • Marginal Utility (MU) – addition to total utility (TU) provided by the last unit of the good consumed

    • MU = Δ TU / Δ Consumption = ∂TU/∂Q

    • MU is the utility provided by the last unit of the good consumed




Law of diminishing marginal utility l.jpg
Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility - as additional units of a good are consumed a point is always reached where the utility derived from each additional unit declines.



Indifference curves l.jpg

Qy

Y2

Y1

IC

X1

X2

Qx

Indifference Curves

  • Indifference Curve (IC) - a line showing all combinations of two goods (products) that provide the same level of utility i.e., the consumer

    is indifferent

    between them

  • As we move along the

    IC the utility level

    remains the same but

    quantities of goods consumed

    change as one good replaces

    (or substitutes) for the other.


Characteristics of indifference curves l.jpg
Characteristics of Indifference Curves

  • The closer to the origin, the lower the level of utility and vice versa.

  • Each IC represents a unique utility level - - Hence, IC can never intersect

  • ICs are negatively sloped. The downward slope of the IC indicates that if the consumer consumes less of one good, she would consume more of the other (for utility to remain constant).

  • The whole set of IC is called an indifference map.

Qy

IC2

IC1

Qx


Indifference curves12 l.jpg

Qy

IC

Qx

Indifference Curves

  • Marginal rate of substitution (MRS) – The number of units of one good that must be given up to receive an extra unit of another good, holding the level of satisfaction constant.

    • MRSXY = Y / X

    • MRS is the slope of the

      indifference curve.

Y2

Y

Y1

X

X1

X2


Marginal rate of substitution l.jpg

Y

X

MRSXY= Y/X

25

5

-6

19

6

-2.50

14

8

-1.33

10

11

-0.75

7

15

-0.40

5

20

Marginal Rate of Substitution

Y

X

1

-6

-5

2

-4

3

-3

4

-2

5


Diminishing marginal rate of substitution l.jpg
Diminishing Marginal Rate of Substitution

  • More the consumer has of a particular good, say X, the less of another good, say Y, he would be willing to give up to obtain an additional unit of X.

  • That is, MRS of X for Y

    gets smaller as the

    consumer has more of X

    and less of Y.

  • This is applicable only

    if Y and X are

    imperfect substitutes.

Y

IC

X


Budget constraint l.jpg

Y

X

Budget Constraint

  • Budget Constraint – price & availability of goods in the market, along with the size of the budget, place a constraint on consumption.

  • Budget and budget

    constraint are

    represented by

    the budget line.


Budget line l.jpg

X

Y

Total Expenditure

30

0

30

24

3

30

18

6

30

12

9

30

0

15

30

Budget Line

  • Budget Line – a line indicating all combinations of two goods that can be purchased using all of the consumer’s budget, i.e., I = XPx + YPy

  • Assume I = 30, PX = 1, & PY = 2


Budget line17 l.jpg

Y

X

Budget Line

  • Every combination of goods along the budget line can be purchased for the same total expenditure.

    • The distance from

      the origin is an indication

      of the size of a the budget.

      • The closer to the origin, the

        lower the budget and vice versa.

    • Only purchases on the

      budget line use all of the

      consumer’s budget.


Budget line18 l.jpg

Y

X

Budget Line

  • I = XPx + YPy

    OR

  • Y=I/Py –(Px / Py) X

  • Where,I/Py is the

    Y-intercept, I/PX is

    the X-intercept and

    - (Px / Py) is the slope

I/PY

Slope = - (Px / Py)

I/PX


Effects of budget changes l.jpg

Y

X

Effects of Budget Changes

  • A budget increase (decrease) will result in a parallel shift of the budget line to the right (left)

  • If the price of one good changes, slope of budget line changes

Y

X


Review of budget line and indifference curve l.jpg

Y

X

Y

IC3

IC2

IC1

X

Review of Budget Line andIndifference Curve

  • Budget Line: a line

    indicating all combinations

    of two goods that can be

    purchased using all of the

    consumer’s budget.

    • Only purchases on the

      budget line use all of the

      consumer’s budget.

  • Indifference Curve (IC):

    a line showing all combinations

    of two goods (products) that

    provide the same level of utility.

    • ICs that are higher in graphs

      represent greater level of satisfaction.


Consumer choice problem l.jpg
Consumer Choice Problem

  • The basic problem a consumer faces is how to allocate the budget among various goods to maximize utility (satisfaction).

  • That is, the consumer’s objective is to select from all combinations of goods within his means (i.e., combinations on his budget line) the one that gives him the maximum utility (i.e., the one that lies on the highest indifference curve.)


Utility maximization decision l.jpg

Y

U

T

S

V

IC3

IC2

W

IC1

X

Utility Maximization Decision


Utility maximization decision23 l.jpg

Y

U

T

S

V

IC3

IC2

W

IC1

X

Utility Maximization Decision

It is then clear that from all the market baskets that are within the consumer’s reach, market basket

“V” would give the consumer the maximum utility.

Note that the market basket V is at a point where the budget line is tangent to IC2.

Thus, the slope of the budget line should be equal to the slope of the indifference curve.


Utility maximization decision24 l.jpg
Utility Maximization Decision

  • Slope of the budget line = PX / PY

  • Slope of the indifference curve

    = MRSXY = Y / X

  • Thus at the point of tangency:

    MRS = Y / X = PX / PY

  • Thus, the consumer maximizes his utility where MRS is equal to the ratio of prices.


Impact of changes in product prices l.jpg
Impact of Changes in Product Prices

  • IF PX increases-X becomes relatively more expensive than Y

    • The slope of the budget

      line increases and the budget

      line rotates inward

    • The consumer can no longer

      afford to remain on original

      indifference curve and must

      move to a lower indifference

      curve

    • The new equilibrium will be at S.

Y

V

S

IC1

W

IC2

X


Impact of changes in product prices26 l.jpg

IC2

Impact of Changes in Product Prices

  • IF PX decreases- X becomes cheaper relative to Y

    • The slope of the budget line

      decreases and the budget line

      rotates outward

    • The consumer can afford to

      move to a higher indifference

      curve

    • The new equilibrium will be at S

Y

S

V

IC1

X


Price consumption curve pcc l.jpg

IC3

Price Consumption Curve (PCC)

  • The PCC connects points representing equilibrium market baskets corresponding to all possible levels of the price of good X, while price of Y and income remain the same.

Y

PCC

a

c

b

IC1

IC2

X


Deriving a demand curve l.jpg
Deriving a Demand Curve

An individual’s demand curve for a particular good is derived from the individual’s budget (budget line) & taste & preferences (indifference curve) or the PCC.

The law of demand states that, ceteris paribus, the quantity of a product demanded will vary inversely to the price of that product.


Slide29 l.jpg

Y

W

V

S

IC3

IC2

IC1

X

PCC

Y3

Y2

Y1

X1

X2

X3

P1

Price of X

P2

P3

Demand Curve for X

X

X1

X2

X3


Deriving a demand curve30 l.jpg
Deriving a Demand Curve

  • Demand Curve – a line connecting all combinations of price and quantities consumed

    • Each point on a demand curve gives the price and quantity combination of a good that a consumer will buy, given his or her budget constraint and the prices of other goods.

    • As the price of a commodity increases (decreases), the quantity demanded of that product decreases (increases).

    • The demand curve slopes downward and to the right.

    • Each point on the demand curve gives a quantity of the good that a consumer will buy to maximize utility.

P1

Price of X

P2

P3

Demand Curve for X

X1

X2

X3

X


Impact of changes in income l.jpg
Impact of Changes in Income

  • A change in income results in a parallel shift of the budget line (slope stays unaffected as long as the prices remain constant)

    • With change in income, the consumer’s utility maximizing market baskets change from “u” to “v” to “w.”

    • If we connect all of the points representing utility maximizing market baskets (u, v, and w) corresponding to all possible levels of income, the resulting curve is call the Income Consumption Curve.

Y

ICC

w

V

U

W

IC3

IC1

IC2

X


Deriving an engel curve l.jpg
Deriving an Engel Curve

The ICC can be used to derive an Engel Curve, which are important for studies of family expenditure patterns.

The Engel Curve describes the relationship between a consumer’s income and his expenditure on a specific good.


Slide33 l.jpg

Y

ICC

w

V

U

IC3

IC1

IC2

X

I

Engel Curve

I3

I2

I1

X

X3

X1

X2


Deriving an engel curve34 l.jpg
Deriving an Engel Curve

  • Engel Curve – a line connecting all combinations of income and quantities consumed

    • Each point on an engel curve gives the income and quantity combination of a good that a consumer will buy, given the prices of all goods.

    • As the income increases (decreases), the quantity demanded of that product increases (decreases). This is true only for normal goods.

    • The shape of the engel curve for a particular good will depend on the nature of the good, the nature of the consumer’s taste, and the level at which the commodity prices are held constant.

I

Engel Curve

I3

I2

I1

X

X3

X1

X2


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