Chapter 4

1. Chapter 4 Demand and Behavior in Markets

2. Impersonal Markets • Impersonal markets • Prices: fixed and predetermined • Identity & size of traders – doesn’t matter • Consumers represented by • Utility function/ preference map • income

3. The Problem of Consumer Choice • Maximize utility • Indifference curve tangent to budget line • MRS = price ratio • On budget line • Quantity demanded of a good • People seek to purchase at a given price

4. Good 2 (x 2) B 20 • Optimal consumption bundle I3 e I2 x1 + x2 = 20 F I1 B’ 20 0 Good 1 (x 1)

5. Income Expansion Paths • Income expansion path • Changes in quantity demanded • Changes in income • Constant prices • Connected optimal consumption bundles • MRS = slope of budget line

6. D 60 Good 2 (x 2) Income expansion path B C 40 r e s 20 B’ C’ D’ Good 1 (x 1) 0 20 40 60

7. Inferior and Superior Goods • Superior good • Income increase • Demand increases • Constant relative prices • Inferior good • Income increase • Demand decreases • Constant relative prices

8. Superior and inferior goods (b) (a) Good 2 (x 2) Good 2 (x 2) Good 1 (x 1) Good 1 (x 1) 0 0

9. Homothetic Preferences • Homothetic preferences • Indifference curves • Do not “rotate” as consumer’s income increases • Along any ray from the origin • MRS – constant • Increase in income • Proportional increase in goods purchased • All goods are superior • No change in tastes

10. Good 2 (x 2) D 60 Income expansion path B C 40 r e s 20 B’ C’ D’ Good 1 (x 1) 0 20 40 60

11. Price-Consumption Paths • Price-consumption path / curve • Consumption changes • One price changes • All other prices – constant • Consumer’s income – constant

12. Price-Consumption Paths • Changing relative prices • Optimal bundle • Indifference curve tangent to budget line • MRS = Price ratio • Good 1 – relatively less expensive • Rotation of budget line – flatter • Good 1 – relatively more expensive • Rotation of budget line – steeper

13. Good 2 (x 2) B 20 -1 2 1/2 1 e B’ B” B* Good 1 (x 1) 0 10 20 40 As the price of good 1 decreases while the price of good 2 remains constant, the budget line becomes flatter, rotating around its point of intersection with the vertical axis (point B).

14. Good 2 (x 2) B 20 -1 2 1/2 1 e B’ B” B* 15 Good 1 (x 1) 0 10 20 40 As the price of good 1 decreases while the price of good 2 remains constant, the budget line becomes flatter, rotating around its point of intersection with the vertical axis (point B).

15. Good 2 (x 2) B Price-consumption path e g f B’ B” a b B* c Good 1 (x 1) 0 As the price of good 1 varies, the price-consumption path traces the locus of tangencies between budget lines and indifference curves.

16. Demand Curves • Demand curve • Relationship between • Quantity demanded • Price • As the price varies • Other things constant • Image of the price-consumption path • Generated: utility-maximizing behavior

17. Price p1=2 • Demand curve for good1 p1=1 p1=1/2 a b c Good 1 (x 1) 0 The demand curve for good 1 associates the optimal quantity of good 1 with its price, while holding income and other prices constant.

18. Demand and Utility Functions • Nonconvex preferences • Optimal consumption bundle • At the corner of the feasible set • Maximize utility • Spend all income on only one good • Demand curve • If price > p*, quantity = 0 • If price = p*, quantity > 0 • As price decreases, quantity increases

19. (b) (a) Price f Good 2 (x 2) k e h B* • Non convex preferences and demand B p1* p* B’ g* Good 1 (x 1) Good 1 (x 1) 0 0 Indifference map. Nonconvex preferences imply optimal consumption bundles at the corners of the feasible set—either point h or point k. Demand curve. Nonconvex preferences imply jumps in the demand curve.

20. Decomposing the Effects of a Price Change • Substitution Effect: change in consumption caused by a change in relative prices • Income Effect: change in consumption as a result of a change in the budget set

21. Substitution Effect • Change in demand due to substitution • One good (decreasing price) • For another good (constant price) • The substitution effect from the decline in price always increases demand

22. Income Effect • Income effect • Decrease in price is equivalent to an increase in real income • The income effect from the decline in price will cause demand to • Increase if the good is normal • Decrease if the good is inferior

23. (a) (b) Price e f g Good 2 (x 2) B p’ D p” p” I1 I2 p’ e D’ B” B’ f Substitution effect Income effect Downward-sloping demand curve The income effect of the price change is measured by the parallel shift of the budget line from DD’ to BB”. The substitution effect is measured by movement around the indifference curve from e to g. Good 1 (x 1) Good 1 (x 1) 0 0

24. e f g Good 2 (x 2) How does the demand curve for good 1 look like? B Inferior Goods: Income and substitution effects work on opposite directions D I2 I1 Substitution effect D’ Income effect B” B’ 0 Good 1 (x 1) The substitution effect of a decline in the price of good 1 causes an increase in demand for the good, the move from e to g. Because good 1 is an inferior good, this is partly offset by the income effect, a decrease in demand for the good from g to f .

25. Giffen Goods and Upward-SlopingDemand Curves • Giffen good • Upper sloping demand curve • Inferior good • A price decrease • Substitution effect • Increase demand • Income effect • Decrease demand • Dominant effect: income effect

26. e f g Good 2 (x 2) B • Giffen good I2 D I1 Substitution effect D’ B” B’ Income effect 0 Good 1 (x 1) The decline in the price of good 1 causes a decline in the demand for that good because the substitution effect (the move from e to g) is more than offset by the income effect (the move from g to f ).

27. Identifying normal and Giffen goods