Consumer choice and demand

decisions

Lec 3
 Specifications of the theory
• The consumer’s tastes and utility Tastes, or preferences, are the driving
force behind what a consumer chooses to consume.
Utility is what economists call the satisfaction consumers get from
consuming goods.
• The behavioural assumption that consumers are rational
By rational, we mean that consumers will try to obtain the best they can
from their consumption decisions.
the affordable consumption bundles, a rational consumer picks the bundle
that maximizes her own satisfaction.
• The consumer’s income :This represents the resource available to the
consumer for the consumption activity.
A consumer cannot consume more than her available income.
• The prices at which goods can be bought.
 assumptions regarding the tastes of a consumer

• Completeness : The consumer can always rank

alternative bundles of goods according to the
satisfaction or utility they provide.
• Transitivity : We assume that the ranking of possible
bundles is internally consistent: if bundle a is
preferred to bundle b and bundle b is preferred to
bundle c, then bundle a must be preferred to bundle c.
• Consumers prefer more to less : If bundle b offers
more films but as many meals as bundle c, we assume
bundle b is preferred. The same applies if bundle b
offers more meals but as many films as bundle c.
 MRS
• The marginal rate of substitution (MRS) between two
goods measures the quantity of a good the consumer must
sacrifice to increase the quantity of the other good by one
unit without changing total utility.
• Consumer tastes exhibit a diminishing marginal rate of
substitution when, to hold utility constant, diminishing
quantities of one good must be sacrificed to obtain
successive equal increases in the quantity of the other
good.
• An indifference curve shows all the consumption bundles
yielding a particular level of utility
 Indifference curves
• indifference curves must slope downwards .
• The slope of a typical indifference curve gets
steadily flatter as we move to the right. This reflects
a diminishing marginal rate of substitution.
• Indifference curves further away from the origin
(higher indifference curves) are associated with
higher levels of utility because the consumer
prefers more to less.
• Indifference curves cannot intersect
 Budget constraint
• The budget constraint describes the different bundles
that the consumer can afford.
• The budget constraint shows the maximum affordable
quantity of one good given the quantity of the other
good being purchased .
• The slope of the budget line shows how many meals
must be sacrificed to get another film. Thus it
represents the opportunity cost .
• Points above the budget line are unaffordable. Points
inside the budget line would allow additional spending.
 Utility maximization and choice
• The budget line shows affordable bundles given a consumer’s
market environment (budget and the price of different goods).
• The indifference map shows tastes.
• We put the two concepts together in order to see how the
consumer chooses among different bundles.
• We assume that the consumer is rational, implying that consumer
chooses the affordable bundle that maximizes his utility.
• He cannot afford points above the budget line and will never
choose points below the budget line (it is then possible to buy
more of one good without sacrificing any of the other good).
• Consumer will select a point on the budget line .
• The chosen bundle will be the point at which an indifference curve
just touches the budget line. The budget line is a tangent to the
indifference curve at this point.
• Wherever the budget line crosses an
indifference curve, a move along the budget
line in the smart direction will increase utility.
Viewed in these terms, point C, which
maximizes utility, is the point at which the
slope of the budget line and the slope of the
indifference curve coincide.
• rational consumer chooses a bundle of goods
at which the marginal rate of substitution (the
slope of the indifference curve) equals the
price ratio (slope of the budget line)
MRS = −PH/PV
 The effect of tastes on consumer choice
• two people have the same budget line. They have the same
income and face the same prices for food and films. Only their
tastes differ
• Figure 5.8(a) shows the chosen point C for the glutton, with a
lot of meals but few films. The glutton has a strong preference
for food (steep indifference curves): her chosen point is far to
the right, where the indifference curve flattens out.
• Figure 5.8(b) confirms that the film buff will choose point C,
with many more films but much less food. The film buff has flat
indifference curves: her chosen point is far to the left before
indifference curves can become flatter than the budget line.
• Our theory of consumer choice successfully translates
differences in taste into observable differences in demand for
the two goods.
DO CONSUMERS REALLY BEHAVE AS UTILITYMAXIMIZING
AGENTS?
• even if we cannot see indifference curves
directly, we can indirectly get information about
them .
• can we infer anything about the preferences of
a consumer by looking at her consumption
choices? The answer is yes
• approach called revealed preferences : The
basic idea is to determine consumers’
preferences from observing consumers’
behavior
 revealed preferences approach
• To briefly illustrate this point, suppose that a consumer faces two
bundles, X and Y. If she chooses X when Y was also affordable, then
we may say that bundle X is revealed as preferred to Y. If our
consumer behaves according to our theory, then we should expect
her always to choose X instead of Y when both bundles are
affordable. If we see our consumer choosing Y instead of X, it should
be the case that X has become unaffordable, otherwise our
consumer does not behave according to our theory.
• The important aspect of revealed preferences is that, if consumer
behavior satisfies some properties (known as the axioms of
revealed preferences), then the consumer is indeed a utility-
maximizing agent.
• The best way to test our theory using revealed preferences is to use
experimental data.
 An increase in consumer income

• An increase in income from £50 to £80 induces a parallel shift in budget line from AF to
A′F′.
• The new end-points A′ and F′ reflect the increase in purchasing power if only one good
is purchased.
• The slope remains unaltered since prices have not changed. At the higher income the
consumer chooses C′.
• Since both goods are normal, higher income raises the quantity of each good demanded
but the percentage increase in film quantity is larger since its income elasticity is higher.
An increase in income reduces demand for the inferior good

• income is increased from £50 to £80 and there is a parallel shift

in the budget line from AF to A′F ′.
• If meals were an inferior good, the quantity demanded would
fall as income rises.
• The consumer then moves from C to C′ when income rises.
Income expansion path for normal goods
Income expansion path and Engel curve for
an inferior good
 Price changes and the budget line

• The consumer beings at point C on the budget line AF.

Doubling meal prices halves the amount that can be spent on
meals when no films are bought. The point F shifts to F′. The
budget line rotates around the point A at which no meals are
bought. Along the new budget line the consumer can no
longer afford the original consumption bundle C. Consumption
of one or both commodities must be reduced.
 Substitution and income effects
• The substitution effect of a price change is the
adjustment of demand to the relative price
change alone.
• The income effect of a price change is the
adjustment of demand to the change in real
income alone.
For a normal good, the income and the substitution
effects move in the same direction.
derived individual demand curve
 Inferior goods
• A Giffen good : A Giffen good is an inferior good for
which the income effect is positive and larger than the
substitution effect (always negative).
• For a Giffen good, the demand curve is upward sloping.
However an inferior good need not be a Giffen good. It
requires a very strong income effect – here, an increase
in demand in response to real income reductions – to
offset the substitution effect that is always negative.
When goods are inferior but not Giffen,
• Demand curve is downward sloping,
 negative cross-price elasticity

• An increase in the price of meals rotates the budget line from AF to AF′. The
substitution effect from C to D is small. Indifference curves have large curvature
since the two goods are poor substitutes in utility terms. The income effect from D
to E implies a large reduction in films for two reasons. First, the reduction in real
income is larger the further to the right the initial point C. Second, films are a luxury
good whose quantity demanded is sensitive to changes in real income. Thus the
income effect outweighs the substitution effect. E lies below C.
 Positive cross-price elasticity

• An increase in the price of meals rotates the budget line from AF to AF′. The
substitution effect from C to D is small. Indifference curves have large curvature
since the two goods are poor substitutes in utility terms. The income effect from D
to E implies a large reduction in films for two reasons. First, the reduction in real
income is larger the further to the right the initial point C. Second, films are a luxury
good whose quantity demanded is sensitive to changes in real income. Thus the
income effect outweighs the substitution effect. E lies below C.
The effect of an increase in the price of good I on
the quantity demanded of goods I and J
 The market demand curve
• The market demand curve is the sum of the
demand curves of all individuals in a particular
market.
Complements and substitutes
 Transfers in kind
• Social security payments are a monetary
transfer. Wages are not: the recipient
provides labour services in exchange for
wages. An example of a transfer in kind is
food stamps
• The consumer has £100 to spend on food or
films, each costing £10 per unit. Figure below
shows the budget line AF.
• Suppose the government issues the consumer
with stamps worth 4 food units. For any point
on the old budget line AF, the consumer can
have 4 more units of food from the food
stamps. Moving horizontally to the right by 4
food units and given that food stamps cannot
buy films, the new budget line is ABF′.
• The consumer can still get at most 10 films.
• that the consumer begins at e′. With a cash
payment, the consumer might move to point c
on the budget line A′F′. The transfer in kind, by
restricting the consumer to the budget line ABF′,
prevents her reaching the preferred point c.
Instead she moves, say, to the feasible point B. B
must yield the consumer less utility than c: when
she got a cash payment and could choose either
point, c was preferred to B.
 Transfers in cash and in kind

• A food transfer in kind may leave consumers less satisfied

than a cash transfer of the same value. A consumer at e′
might wish to spend less than the full allowance on food,
moving to c. The budget line is A ′BF′ under a cash transfer.
The in-kind transfer restricts the budget line to ABF′.
 MARGINAL UTILITY AND THE WATER–DIAMOND PARADOX
• Nineteenth-century economists wondered why the price of water,
essential for survival, was so much lower than that for decorative
diamonds.
• One answer is that diamonds are scarcer than water. Yet consumers
clearly get more total utility from water (without it, they die) than
from diamonds.
• The concept of marginal utility solves the problem.

• We know that consumers keep buying a good until the ratio of its
marginal utility to price equals that for other goods. At the margin,
the last litre of water we drink or use in the shower gives very little
extra utility.
• At the margin, the last diamond still makes a big difference. People
are willing to pay more for extra diamonds than for extra water.
 CHAPTER 6

Introducing supply decisions

• A sole trader is a business owned by a single
individual.
• A partnership is a business jointly owned by
two or more people, sharing the profits and
being jointly responsible for any losses.
 firm’s accounts
• Stocks are measured at a given point in time; flows are corresponding
measures during a period of time.
• Revenue is what the firm earns from selling goods or services in a given
period,cost is the expense incurred in production in that period and profit
is revenue minus cost.
• cash flow is the net amount of money actually received during the period.
• Physical capital is machinery, equipment and buildings used in production.
• Depreciation: the loss in value of a capital good during the period.
• Inventories are goods held in stock by the firm for future sales.
• A firm’s net worth is the assets it owns minus the liabilities it owes.
• Retained earnings are the part of after-tax profits ploughed back into the
business.
 Opportunity costs and accounting costs
ECONOMIC VS ACCOUNTING PROFITS

• The inclusion of opportunity costs in economic profits creates an important distinction from the concept of
accounting profits. To stress this distinction further, suppose you start your own firm. Suppose that your
total revenues are £60 000 and you have explicit costs of £40 000 (for example, wage payments to your
workers, the cost of raw materials and so on). According to those numbers, you should obtain an
accounting profit of £20 000.
• However, suppose that your best alternative was to work for someone else and receive a wage of £25 000.
Then your firm, according to an economist, is running at a loss of £5000.
• The £25 000 you could have earned somewhere else represents the opportunity cost of your time working
in your firm and should be included in the total costs. This opportunity cost enters the economic profits
but not the accounting profits.
• According to accounting profits, your firm is profitable. According to economic profits, your firm is not
profitable. So, in our definition of economic profits we also include in the total costs the remuneration that
the owner of the firm obtains by running the firm.
• This remuneration is called normal profit and it is included in the total cost of our economic profit
definition. This is very important because, in many cases, we will say that firms earn zero profits. Zero
profit for us will mean zero economic profits. It means that remuneration of the owner is exactly equal to
• the opportunity cost of running the firm. In our example, suppose that the total revenues were £65 000.
The opportunity cost is still £25 000 and the explicit costs are £40 000. In this case, the economic profits
are zero .This does not mean that the owner of the firm gets nothing from his business .He will get a
positive remuneration (£25000) but that remuneration is exactly equal to remuneration he could have
obtained from his best alternative.