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8/6/2019 Econ 103 Part 04
1/27
Part 4The Theory of Demand
We have drawn all our demandcurves downward sloping
Why do economists thinkdemand curves normally slope
downward? Market demand curves are
aggregations of individual (orhousehold) demand curves
What factors will affect ahouseholds demand for agood?
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Household ConsumptionChoices
Households buy a variety of goods(a bundle of goods)
Different households buy differentbundles of goods
Household choice will depend on:
- income
- relative prices of goods
- preferences
Income and prices can be shown in abudget constraint
What shapes preferences?
How can a given set of preferences
be represented?
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Budget Constraint
Qy
Qx
Affordable
Unaffordable
Budget constraint with given income = I
and given prices Px and Py:
I = PxQx + PyQy
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Preferences and Utility
Which of the affordable
combinations will a householdchoose to purchase?
The intuitive answer is that thehousehold will choose the bundle of
goods that it likes the best orprovides the most satisfaction of allthe affordable bundles
More formally, if the degree of
satisfaction of all wants and desirescan be measured on a single utilityscale, the household will choose thebundle of goods that maximizes
utility
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Cardinal Utility Theory
When the idea of a utility measure
was first proposed in economics itwas 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 ofeach other (eg: deg F = 32 + 9/5 C)
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Total and MarginalUtility
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?
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Maximizing Utility
Quantity MUx MUy
1 20 16
2 18 15
3 14 14
4 8 13
5 0 12
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
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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 allgoods
Rule for a utility maximum:
MUx/Px = MUy/Py orMUx/MUy = Px/Py
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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 willfall (increasing MUy)
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Individual and MarketDemand
Market demand curves are the
horizontal summation of the
demand curves of all
individuals or households
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Ordinal Utility Theory
The idea of utility asmeasurable in a cardinal waywas subject to much criticism
The idea of a utility measure as
a rank ordering replaced theidea of cardinal measurement
An ordinal measure is aranking only.
No unit of measurement
Higher numbers imply onlymore preferred
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Preferences
Qy
Qx
Definitely
Less preferred
to A: U5
Bundle A: X,Y
U=5
If both X and Y provide utility
X
Y
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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
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A Preference Map
U=5
U=6
Qy
Qx
a
b
c
d
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Preference Maps
In order to draw a preferencemap at all we are assuming:
goods are infinitely divisible(indifference curves are
continuous) Every combination of goods can
be ranked (preferences arecomplete)
Preferences are consistent(indifference curve cannotintersect or touch)
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The Shape ofIndifference curves
Negative slope (more is
preferred to less)
Marginal rate of substitution
(MRS)
Convex to the origin
(diminishing marginal rate of
substitution)
MRS=Qy/Qx keeping utilityconstantslope of the
indifference curve
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Maximizing UtilityOnce Again
In the ordinal utility context
maximizing utility means choosingthat 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)QxI/Py is the Y intercept
Px/Py is the slope of the budget line
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Budget line
I/Px Qx
Qy
I/Py
I = PyQy+PxQx
Px/Py is the slope of the budget line
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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 curvewhere MRS=Px/Py
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Changes in Income
Changes in income with constant
prices will shift the budget lineoutwards 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 ofindifference curves)
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Income EffectQy
QxQx Qx
U
U
I
I
Income consumption line
X and Y normal
Qy
Qx
I
IU
U
Qx Qx
X inferior, Y normal
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Changes in Price
Change in the price of X
changes the slope of the budget
line by changing the X intercept
Qy
QxI/Px I/Px
Px>PxI/Py
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Price Effect and DemandCurves
Qy
Qx
Qx
Px
U
U
Qx Qx
Qx Qx
Budget line
with Px
Px
Budget line
with Px
Px
Demand curve for X
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Income and Substitution
Effects of a PriceChange
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 relativeprices keeping real income
(utility) constant
The income effect is the effecton real purchasing power of the
price change
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Income and Substitution
Effects of a PriceChange
Qy
QxQx Qxs Qx
Sub Inc
ab
s
Overall effect (a to b) can be
broken down into a substitution
and income effect
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Income and Substitution
Effects of a PriceChange
Income effects of a price change are
usually small--unless the goodaccounts for a high proportion of
expenditure
For normal goods the income effect
works to reinforce substitution effect
and a price decline mustincrease
quantity demanded
For inferior goods the income effectworks against the substitution effect,
but the substitution effect is usually
larger
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Income and Substitution
Effects of a PriceChange
What does it take to get an
upward sloping demand curve?The Giffen good case
Giffen goods must be both
inferior and important in thebudget
Very unlikely to come across aGiffen good
Policy uses of income andsubstitution effects--carbontaxes and income tax rebates