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The Theory Of Demand
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The Theory Of Demand

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  • 1. Part 4 The Theory of Demand
    • We have drawn all our demand curves downward sloping
    • Why do economists think demand curves normally slope downward?
    • Market demand curves are aggregations of individual (or household) demand curves
    • What factors will affect a household’s demand for a good?
  • 2. Household Consumption Choices
    • Households buy a variety of goods (a “bundle” of goods)
    • Different households buy different bundles of goods
    • Household choice will depend on:
    • - income
    • - relative prices of goods
    • - preferences
    • Income and prices can be shown in a budget constraint
    • What shapes preferences?
    • How can a given set of preferences be represented?
  • 3. Budget Constraint Qy Qx Affordable Unaffordable Budget constraint with given income = I and given prices Px and Py: I = PxQx + PyQy
  • 4. Preferences and Utility
    • Which of the affordable combinations will a household choose to purchase?
    • The intuitive answer is that the household will choose the bundle of goods that it “likes the best” or provides the most satisfaction of all the affordable bundles
    • More formally, if the degree of satisfaction of all wants and desires can be measured on a single “utility” scale, the household will choose the bundle of goods that maximizes utility
  • 5. Cardinal Utility Theory
    • When the idea of a utility measure was first proposed in economics it was sometimes assumed that one could think of units of utility in the same way as units of weight or temperature
    • Such a measure has a defined unit that can be added, multiplied, & etc
    • Many possible units of measure but they are all linear transformations of each other (eg: deg F = 32 + 9/5 C)
  • 6. Total and Marginal Utility
    • More goods give more total utility
    • More of any particular good will tend to give less additional total utility with each increment
    • Diminishing marginal utility
    • Diminishing marginal utility and the “paradox of value”
    • What is the rule for maximizing total utility out of a given budget when each good has diminishing marginal utility?
  • 7. Maximizing Utility Example of two goods x and y Utility maximizing bundle with an income Of $6 and Px and Py= $1? Utility maximizing bundle with an income $16 and Px=$3 and Py=$2 15 18 2 12 0 5 13 8 4 14 14 3 16 20 1 MUy MUx Quantity
  • 8. Maximizing Utility
    • The total utility gained from a given budget will be maximized where the budget is all spent and marginal utility per dollar spent is equalized across all goods
    • Rule for a utility maximum:
    • MUx/Px = MUy/Py or
    • MUx/MUy = Px/Py
  • 9. Implications
    • Maximization is where
    • MUx/Px = MUy/Py
    • Fall in Px will increase quantity demanded for X (decreasing MUx)
    • Fall in Px will also affect the demand for Y. If X and Y are substitutes demand for Y will fall (increasing MUy)
  • 10. Individual and Market Demand
    • Market demand curves are the horizontal summation of the demand curves of all individuals or households
  • 11. Ordinal Utility Theory
    • The idea of utility as measurable in a cardinal way was subject to much criticism
    • The idea of a utility measure as a rank ordering replaced the idea of cardinal measurement
    • An “ordinal” measure is a ranking only.
    • No unit of measurement
    • Higher numbers imply only more preferred
  • 12. Preferences Qy Qx Definitely Less preferred to A: U<5 Definitely Preferred to A: U>5 Bundle A: X’,Y’ U=5 If both X and Y provide utility X’ Y’
  • 13. Indifference Curves A locus of all bundles with the same utility ranking. The consumer is indifferent between them U=5 U>5 (preferred to Any point on U=5) U<5 (any point on U=5 preferred) Indifferent between any point on U=5 Qy Qx
  • 14. A Preference Map U=5 U=6 Qy Qx a b c d
  • 15. Preference Maps
    • In order to draw a preference map at all we are assuming:
    • goods are infinitely divisible (indifference curves are continuous)
    • Every combination of goods can be ranked (preferences are complete)
    • Preferences are consistent (indifference curve cannot intersect or touch)
  • 16. The Shape of Indifference curves
    • Negative slope (more is preferred to less)
    • Marginal rate of substitution (MRS)
    • Convex to the origin (diminishing marginal rate of substitution)
    • The degree of substitutability and the shape of the indifference curves
  • 17. Maximizing Utility Once Again
    • In the ordinal utility context maximizing utility means choosing that bundle of goods that is on the highest indifference curve achievable with given income and prices
    • Budget line: I = PyQy+PxQx
    • PyQy = I- PxQx
    • Qy = I/Py – (Px/Py)Qx
    • I/Py is the Y intercept
    • Px/Py is the slope of the budget line
  • 18. Budget line I/Px Qx Qy I/Py I = PyQy+PxQx Px/Py is the slope of the budget line
  • 19. Utility Maximization: Indifference Curves U=5 Qx Qy Qy* Qx* Highest indifference curve achievable U=4 U=6 Budget line and indifference curve are tangent. On budget line and highest indifference curve where MRS=Px/Py
  • 20. Changes in Income
    • Changes in income with constant prices will shift the budget line outwards in a parallel fashion
    • Normal goods will show increased consumption with higher income
    • Inferior goods will show decreased consumption with higher income
    • Consumer preferences determine if a good is normal or inferior (shape of indifference curves)
  • 21. Income Effect Qy Qx Qx’ Qx” U” U’ I’ I” Income consumption line X and Y normal Qy Qx I” I’ U’ U” Qx” Qx’ X inferior, Y normal
  • 22. Changes in Price
    • Change in the price of X changes the slope of the budget line by changing the X intercept
    Qy Qx I/Px’ I/Px” Px’>Px” I/Py
  • 23. Price Effect and Demand Curves Qy Qx Qx Px U’ U” Qx’ Qx” Qx’ Qx” Budget line with Px” Px” Budget line with Px’ Px’ Demand curve for X
  • 24. Income and Substitution Effects of a Price Change
    • The effect of a price change on the demand for a good can be decomposed into two effects
    • The substitution effect is the effect of the change in relative prices keeping real income (utility) constant
    • The income effect is the effect on real purchasing power of the price change
  • 25. Income and Substitution Effects of a Price Change Qy Qx Qx’ Qxs Qx” Sub Inc a b s Overall effect (a to b) can be broken down into a substitution and income effect
  • 26. Income and Substitution Effects of a Price Change
    • Income effects of a price change are usually small--unless the good accounts for a high proportion of expenditure
    • For normal goods the income effect works to reinforce substitution effect and a price decline must increase quantity demanded
    • For inferior goods the income effect works against the substitution effect, but the substitution effect is usually larger
  • 27. Income and Substitution Effects of a Price Change
    • What does it take to get an upward sloping demand curve? The “Giffen” good case
    • Very unlikely to come across a Giffen good
    • Policy uses of income and substitution effects--carbon taxes and income tax rebates