Economic Analysis for Management

Lecture 7 & 8

IME, IIT Kanpur

Numerical Problem

Consider the utility function U(x, y ) = x 0.4 y 0.6 . (This is called

Cobb-Douglas utility function).
a) Is the assumption of Monotonicity satisfied for both goods?
b) Does the marginal utility of x diminish, remain constant, or
increase as the consumer buys more x?
c) What is MRSx,y for this utility function?
d) Is it diminishing, constant or increasing along an indifference
curve?
Price Index - once more

Let market basket contain only rice, dal, oil.

The base year is 2000. The current year 2022.
PR (Y ), PD (Y ) and PO (Y ) are prices of rice, dal and oil in year Y .
▶ The Ideal cost of living index: represents the cost of attaining a
given level of utility at current (2022) prices relative to the cost of
attaining the same utility at base (2000) prices.
▶ But constructing such a price index will need information on
consumer preferences, prices and expenditures.
▶ Actual prices indices are therefore based on actual purchases by
consumers, not preferences.
Two approaches to calculate prices indices
Let market basket contain only rice, dal, oil.
The base year is 2000. The current year 2022.
PR (Y ), PD (Y ) and PO (Y ) are prices of rice, dal and oil in year Y .
Then,
▶ Laspeyres Index: Considers the the consumption basket in the
base year as constant.
PR (22)R(00)+PD (22)D(00)+PO (22)O(00)
Expression: PR (00)R(00)+PD (00)D(00)+PO (00)O(00)

▶ Generally, the Laspeyres index is greater than ideal price index.

This is because we do not allow the consumer to adjust her
basket according to price changes.
▶ Paasche Index: Considers the consumption basket in the current
year as constant.
PR (22)R(22)+PD (22)D(22)+PO (22)C(22)
Expression: PR (00)R(22)+PD (00)D(22)+PO (00)O(22)

▶ The Paasche index is generally smaller than ideal price index.

This is for the same reason.
Individual and Market Demand
Introduction

▶ We mentioned that we can derive the demand curve from

consumer choice theory. We start this topic with that exercise.
▶ First, we shall do so graphically.
▶ Then we shall see a mathematical treatment.
▶ Then we shall discuss a few other important concepts.
▶ Let us start with individual demand.
Individual Demand when price changes
▶ The individual demand curve can be
drawn from the consumer behaviour
framework.
▶ The initial budget line is the line in
the middle. Consumer maximizes
utility at point B (food price = $1).
▶ An increase/decrease in food price
($2 for the inner line and $0.50 at the
outer line) rotates the budget line.
Also, utility maximizing points change
▶ Clearly, food consumption is
negatively related with price of food.
That is what is plotted in the figure at
the bottom.
▶ Note: Do we know how clothing
consumption changes from the
information given? No.
▶ Therefore we cannot comment on the
price-consumption curve, with the
Source: Microeconomics 8e, by Pindyck and Rubinfeld
given information.
Individual Demand when price changes - II

Two properties of the demand curve:

▶ Utility keeps increasing, as price for falls. How do we know? The
indifference curves keep moving toward right from A to B to D.
▶ MRSF ,C at the utility maximizing points keeps falling as price of
food falls. How do we know? MRS = Price of food to price of
clothing, which is falling as we move outward.
Individual Demand when income changes

▶ As income changes, prices remaiing

fixed, budget line moves outward.
▶ Income is an exogenous variable in
the demand curve. Therefore, its
change causes shifts of the curve.
▶ The bottom figure draws the demand
curves.
▶ The points in the demand curve are
for the same price. Why?
▶ Because MRSF ,C are same at points
A, B and D.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

 Normal vs Inferior goods
Source: Microeconomics 8e, by Pindyck and Rubinfeld
▶ In the figure in the last slide, the
income-consumption curve has a
positive slope.
▶ This means that demand increases
with income. As a result, the income
elasticity of demand ( ∆Q/Q
∆I/I
)is
positive.
▶ In such cases, the goods are
described as normal: Consumers
want to buy more of them as their
incomes increase.
▶ In some cases, the quantity
demanded falls as income increases;
i.e., the income elasticity of demand
is negative.
▶ in such cases, the good is inferior.
The term inferior simply means that
consumption falls when income rises.
▶ Example of Burger consumption in
the US.
Engel curve
Engel curves relate the quantity of a good consumed to income. In (a), food is a
normal good and the Engel curve is upward sloping. In (b), however, hamburger is a
normal good for income less than $20 per month and an inferior good for income
greater than $20 per month.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Deriving demand curve mathematically

▶ Consume’s utility function U(x, y ) = xy , say

▶ Consumer’s budget constraint: Px x + Py y = I.
▶ ∂f /∂x = MUx = y and ∂f /∂y = MUy = x.
▶ Therefore, the slope of the indifference curve is: −y /x.
▶ Slope of the budget line is: = −Px /Py .
▶ The optimality condition is: y /x = Px /Py ., or yPy = xPx .
▶ Using the budget line equation: x = I/2Px .
Substitutes and Complements - once more

▶ Two goods are substitutes if an increase in the price of one leads

to an increase in the quantity demanded of the other.
▶ Two goods are complements if an increase in the price of one
good leads to a decrease in the quantity demanded of the other.
▶ Two goods are independent if a change in the price of one good
has no effect on the quantity demanded of the other.
Income and Substitution Effects

A fall in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has become
cheaper and less of those goods that are now relatively more
expensive. This response to a change in the relative prices of
goods is called the substitution effect.
2. Because one of the goods is now cheaper, consumers enjoy an
increase in real purchasing power.The change in demand
resulting from this change in real purchasing power is called the
income effect.
Normally, these two effects occur simultaneously, but it will be useful
to distinguish between them for purposes of analysis.
Income and Substitution Effects - Normal good
▶ The initial budget line is RS. The consumer maximizes utility at
point A.
▶ Price of food falls. The budget line rotates outward. New
maximization happens at B.
▶ This change from A to B can be broken into two effects.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Income and Substitution Effects - Normal good - II
▶ The first component is the substitution effect. Only the consumption basket
changes, keeping the utility constant.
▶ Shown as a move from point A to D.
▶ For food consumption, the effect if F1 E.
Income and Substitution Effects - Normal good - III
▶ The second component is the income effect. There is a parallel shift of the
rotated budget line. So, the relative price is constant.
▶ Now, both consumption basket as well as utility changes.
▶ Shown as a move from point D to B.
▶ For food consumption, the effect if EF2 .
▶ Since food is a normal good, income effect is positve

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Income and Substitution Effects - Inferior good
▶ In this case, the substitution effect remain same as earlier.
▶ Movement of basket from A to D is the substitution effect. For
food, the effect is given by F1 E.
▶ However, the income effect is now negative.
▶ Basket changes from D to B. For food, the effect is EF2 .
▶ Important: The same can be shown for a rise in price for food as
well.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

The Giffen good

▶ This happens when the income effect is negative, and so large

that it is greater than the substitution effect.
▶ In this case the demand curve is upward sloping.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Market Demand Curve

▶ So far we were discussing the derivation of demand curve for a

‘typical’ individual.
▶ We were looking at the utility and indifference curve related to it
for a consumer, and also the budget constraint the consumer
faces.
▶ Now, we attempt to explore how the individual demand curves
can be aggregated across individuals to attain a demand curve
for a particular market.
▶ It’s easy! We just have to add the quantities demanded by the
individuals at a price, and continue doing this for all prices.
▶ The aggregation of individual demands into market becomes
important in practice when market demands are built up from the
demands of different demographic groups or from consumers
located in different areas.
Market Demand Curve - II
The Market Demand Curve is the horizontal summation of the individual
demand curve.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

1. The market demand curve will shift to the right as more consumers
enter the market.
2. Factors that influence the demands of many consumers will also affect
market demand.
Example

We consider a market for orange juice. There are two consumers in

the market, health-conscious consumer, and casual consumer.
Qc = 6 − 2P. Qc for this curve is zero when P = 3.
Qh = 15 − 3P. Qh for this curve is zero when P = 5.

Then the market demand curve will be given by:

(
21 − 5P, if P < 3
Qm =
15 − 3P, if 3 ≤ P < 5
Isoelastic Demand
When the price elasticity of demand is constant all along the demand
curve, we say that the curve is isoelastic. The figure below shows an
example, when price elasticity of demand is -1.
Note that for this demand curve, the expenditure remains constant.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Consumer Surplus

▶ Consumer surplus measures how much better off consumers are

after buying a good, given their willingness to pay, and price of
the good in the market.
▶ It is the difference between the maximum amount they are willing
to pay and the price of the good.
▶ Suppose you wanted to spend Rs. 1000 for buying the
Microecononomics book. You visit a bookshop, and find the price
is Rs.700. Then Rs. 300 is your consumer surplus.
▶ But different consumers value a good differently.
▶ Also, the same consumer may be willing to pay different amounts
for buying different quantities.
▶ We aggregate consumer surpluses for all different scenarios to
get the total consumer surplus in a market.
Consumer Surplus and Demand
– Consumer surplus can be calculated easily from the demand curve.
– We follow the example of buying multiple rock concert tickets by a student.
– Drawing the demand curve as a staircase rather than a straight line shows us how
to measure the value that our student obtains from buying different numbers of
tickets.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Consumer surplus = $(6 + 5 + 4 + 3 + 2 + 1) = $21.

Aggregate consumer surplus in a market
– When we add the consumer surpluses of all consumers who buy a good, we
obtain a measure of the aggregate consumer surplus.
– To calculate the aggregate consumer surplus in a market, we simply find the area
below the market demand curve and above the price line.
– This is because when we add individual demands for many consumers, the steps
will (almost) disappear.

Market consumer surplus is: 1/2(20 − 14) 6, 500 = $19, 500.

Network externalities

– So far, we have assumed that people’s demands for a good are

independent of one another.
– This assumption has enabled us to obtain the market demand
curve simply by summing individuals’ demands.
– For some goods, however, one person’s demand also depends on
the demands of other people. Moreover, the demand may depend
upon number of other people consuming it.
– A positive network externality exists if the quantity of a good
demanded by a typical consumer increases in response to the growth
in purchases of other consumers. Example: using WhatsApp.
– The opposite is true for negative network externality. Example:
Visitng a tourist spot.
Positive Network externalities
Bandwagon effect is an example of Positive network externality in
which a consumer wishes to possess more a good in part because
others do.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Negative Network externalities
Snob effect is an example of Negative network externality in which a
consumer wishes to an exclusive good.

Source: Microeconomics 8e, by Pindyck and Rubinfeld