Consumer Equilibrium and Market Demand Chapter 4 Discussion Topics What are the conditions that describe 2 your initial purchase decision? What makes you change your purchase decision? A representation of the law of demand What is meant by tastes and preferences Use of consumer surplus for benefit calculation Measurement and Interpretation of Consumer Equilibrium (Purchase Decision) 3 Consumer Equilibrium Remember that utility represents the level of satisfaction obtained from alternative bundles (or collection) of goods Assume the consumer wants to maximize utility given his/her limited budget We also assume that utility only impacted by the consumption of market goods (i.e. price exists) How can we represent this problem graphically and mathematically? Page 54 Consumer Equilibrium Point A is consumer equilibrium Good 2 U4 U2 G2 * A → Slope of Indifference Curve = Slope of Budget Line →MRS12= – P1/P2 → At A, MU1/MU2 = P1/P2 → At A, on the boundary of the budget set and on highest indifference curve Budget Constraint ($C*) U3 U1 < U2 < U3 < U4 U1 G1* Good 1 Previously: Slope of Indifference Curve =MRS Slope of budget line = price ratio 5 Page 54 Consumer Equilibrium Point A can be interpreted as Good 2 the combination of goods that generates The maximum utility (U3) While being limited by a fixed budget ($C*) U4 U2 G2 * A U3 U1 G1* 6 Good 1 Page 54 Consumer Equilibrium Point A can also be interpreted Good 2 C3* C1*< C2*< C3* as the combination of goods C2* C1 * G2 * A that generates The minimum cost ($C*) While generating a desired level of utility (U3) U3 G1 * Good 1 Why are these parallel shifts of the budget constraint? 7 Page 54 Consumer Equilibrium We can rearrange the above equilibrium conditions: MU1 P1 MU1 P1 MU1 MU 2 MU 2 P2 MU 2 P2 P1 P2 → the marginal utility derived from last dollar spent on each good, MUi/Pi, is identical This can be expanded to include all goods and services purchased by the consumer Lets extend this to the textbook example of 8 tacos vs. hamburger consumption Page 54 Utility is maximized by Consumer Equilibrium $5 initial budget 9 buying 5 tacos @ $0.50 2 hamburgers @ $1.25 Total expenditures equals the weekly budget of $5.00 Page 54 Consumer Equilibrium Points B and D exceed the $5 budget How can you tell? 10 Page 54 Consumer Equilibrium Point C does not maximize utility How can you tell? Page 54 11 Consumer Equilibrium What happens to the above consumer equilibrium when the price of one of the products changes? Will consumption of both goods change even though only 1 price impacted? Lets assume the price of Hamburgers (PH) changes $5.00 $1.25 (Current Price) $1.00 12 Page 54 Effect of Price Changes Under original budget line ED: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium: 11 Taco Consumption per Week 10 E 9 8 7 6 5 Tacos 2 Hamburgers A 5 4 3 2 1 D 1 13 2 3 4 5 6 Hamburger Consumption per Week Page 54 Effect of Price Changes Budget Line when PH decreases from $1.25, EF: Price of Hamburgers (PH) = $1.00 Price of Tacos (PT) = $0.50 10 Income = $5.00 Equilibrium moves from A to B: 11 Taco Consumption per Week 10 E 9 8 4 Tacos 3 Hamburgers 7 6 A 5 B 4 3 2 1 F D 1 14 2 3 4 5 Hamburger Consumption per Week 6 Page 54 Effect of Price Changes Budget Line when PH increases to $5.00, EG: Price of Hamburgers (PH) = $5.00 Price of Tacos (PT) = $0.50 Income = $5.00 Equilibrium moves from A to C: 11 Taco Consumption per Week 10 E 9 5 Tacos 0.5 Hamburger 8 7 6 5 A C B 4 3 2 1 G 1 15 D 2 3 4 F 6 Hamburger Consumption per Week Page 54 Effect of Price Changes Line CAB represents a consumer demand schedule for hamburgers 11 Taco Consumption per Week 10 Shows how the consumer responds to changes in a good’s price ↑ in price, ↓ in quantity demanded Other prices and total expenditures do not change E 9 8 7 6 C A 5 4 Only hamburger price changing B 3 2 1 D 1 16 2 3 4 F 6 Hamburger Consumption per Week Page 54 Effect of Price Changes Lets collect the equilibrium points for the three hamburger price scenarios Equilibrium Point C A PH ($/lb) $5.00 $1.25 QH (No.) 0.5 2.0 B $1.00 3.0 We can then graph the quantity purchased at each 17 price level Vertical axis is price Horizontal axis is quantity Graph referred to as the demand curve for hamburgers Page 54 Consumer Equilibrium This graph shows the demand curve for hamburgers PH($/Burger) $5.00 ̶ C What is the relationship between price and quantity demanded? Pts. C, A and B correspond to same points on Slide 16 A $1.25 ̶ $1.00 ̶ B ̶ ̶ ̶ 18 0.5 2.0 3.0 QH(No. of Burgers) Page 54 Effect of an Income Change Original Budget Line, KJ: Price of Hamburgers (PH) = $1.25 Price of Tacos (PT) = $0.50 Income = $5.00 11 Taco Consumption per Week 10 K 9 8 7 6 Original Equilibrium: 5 tacos/2 hamburgers A 5 4 3 2 1 J 1 19 2 3 4 5 6 Hamburger Consumption per Week Page 54 Effect of an Income Change 13 12 11 Taco Consumption per Week 10 G Budget Line KJ: Income = $5.00 Budget Line GF: Income = $6.00 K Both hamburgers and tacos New Equilibrium 9 8 7 6 B 5 A 4 3 2 Original Equilibrium 1 F J 1 20 2 3 4 5 are normal goods as budget increased from $5 to $6/week Normal goods are goods whose demand increases with higher budget (income) and decreases with lower budget (income) 6 Hamburger Consumption per Week Page 54 Effect of an Income Change 16 Budget Line KJ: Income = $5.00 Budget Line GF: Income = $6.00 Budget Line ED: Income = $8.00 E 15 14 Taco Consumption per Week 13 12 11 G 10 K Tacos become an inferior good when budget (income) increased to $8/week 9 Inferior goods are goods whose demand ↓ with ↑ in the budget and ↑ with ↓ in the budget 8 7 6 B A 5 C 4 3 2 1 J 21 1 2 3 4 D F 5 6 Page 54 Effect of an Income Change We can plot demand Taco Consumption per Week 13 12 11 G 10 K levels under alternative budgets (income) Referred to as an Engel Curve 9 8 7 6 B A 5 C 4 3 2 1 22 1 2 3 4 D F J 5 6 Page 54 Effect of an Income Change Hamburger Engel Curve 23 Typical shape of a normal good’s Engel curve over all income levels Tacos Engel Curve Example of an Engel curve for a good that is an inferior good at higher income (budget) levels Page 58 Measurement and Interpretation of Market Demand 24 Concept of Market Demand The above model of consumer behavior focused on a single individual We can extend the above model to one where we refer to overall or total market demand for a city, county, state, country, etc. 25 Concept of Market Demand Notice the kink @ $2 The market demand curve for a good is the horizontal summation of demand schedules for all the consumers in the particular market In the above example with PH = $1.50 Paula purchases 2 hamburgers/week while Beth purchases 1 hamburger → market demand = 3 hamburgers @ a price $1.50/hamburger 26 Page 59 Demand Curve Description When discussing events in the market place economists use specific terms to distinguish between movement along a demand curve vs. a shift in a demand curve Movement along a demand curve referred to as a change in quantity demanded Only 1 demand curve, just a different point on it Alternatively a shift in the demand curve referred to as a change in demand Need not be a parallel shift in the demand curve 27 Movement from point A to C is referred to as a change in demand Movement from point A to B is called a change in quantity demanded 28 Page 61 Demand Curve Description Reasons for a change in a demand curve Change in household income Change in population characteristics Number of children Change in marital status Household composition Price of substitutes Change in anything other then ownprice 29 Concept of Consumer Surplus A characteristic of market demand curve Concept of consumer surplus (CS) or economic well-being CS is derived from consumption and the fact we have a negatively sloped demand curve (with respect to its own-price) A demand curve reveals the willingness of consumers to pay a certain price for a particular quantity of a good 30 Page 63-64 Concept of Consumer Surplus As we showed earlier, consumers are willing to pay a higher price for a lesser quantity $/unit Why do consumers want to pay less/unit when consuming more? P2 P2 > P1 Q2 < Q1 B A P1 Q2 Q1 Q Actually do not have to pay the higher price given the level of supply coming into the market → Consumers realize a savings 31 Page 63-64 Quantifying Consumer Surplus $ Area ABC is the consumer surplus B 11 when market price is $6. 10 9 8 7 6 C A 5 Demand curve implies consumers are willing to pay $10 for the 1st unit, $9 for the 2nd unit, etc. Only had to pay $6 each for all 5 units E Area DACE is the gain D 4 in consumer surplus if the price falls to $5 3 2 1 0 32 Q 1 2 3 4 5 6 7 8 9 10 11 Page 63 Quantifying Consumer Surplus $ B 11 The level of consumer surplus with a linear demand curve is [(Height × Length)/2] = ([$11-$6]×5)/2=$12.50 10 9 8 7 6 5 4 A C D E Height Again, why do we have a consumer surplus? 3 2 1 0 33 1 2 Q 3 4 5 6 7 8 9 10 11 Page 63 In Summary Consumer equilibrium for an individual for a given price and budget Individual consumer’s demand schedule Market demand curve Engel curves Change in demand vs. change in quantity demanded Consumer surplus Chapter 5 examines the concept of an elasticity, one of the most important concepts in all of economics….