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Understanding the Demand Curve and Consumer Choice: Income and Substitution Effects

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fuller-craig
25 diapositives · 403 Views · Nov 07, 2014

This article explores the concepts of the demand curve and consumer choice, highlighting the income and substitution effects that influence consumer behavior. The income effect explains how a change in the price of a good impacts a consumer's real income, affecting the quantity demanded. The substitution effect describes how price changes alter the relative cost of goods, leading consumers to substitute items accordingly. Additionally, it delves into utility, marginal utility, and the law of diminishing marginal utility, presenting ways for consumers to achieve equilibrium in their purchasing decisions.

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  1. Explanations of the Demand Curve • & Consumer Choice

  2. The Income and Substitution Effect combine to make a consumer able and willing to buy more of a specific good at a low price than at a high price. Income effect is the impact on a consumer’s real income of a change in the price of a product and consequently the quantity of the produce demanded. When the price of a good decreases, people can buy more with the same income. When the price of a good increases, people need to buy less with the same income.

  3. Substitution effect is the impact that a change in the product’s price has on its relative expensiveness and consequently on the quantity demanded. When the price decreases, the good is less expensive relative to other similar goods. We substitute with the now lower priced good. When the price increases, the good is more expensive relative to other similar goods. We substitute with the now lower priced good.

  4. What is Utility? • The satisfaction or enjoyment a person obtains from consuming a good

  5. What is a Util? • A hypothetical unit used to measure how much utility a person obtains from consuming a good

  6. Marginal Utility • The change in total utility a person derives from consuming an additional unit of a good

  7. Total Utility • The total number of utils a person derives from consuming a specific quantity of a good

  8. TU and MU • Q TU MU • 0 0 • 1 10 10 • 2 18 8 • 3 24 6 • 4 28 4 • 5 30 2 • 6 30 0 • 7 28 -2

  9. Law of Diminishing Marginal Utility • After a point, as more of a good is consumed, the marginal utility (MU) a person derives from each additional unit diminishes.

  10. TU Total Utility increases at a diminishing rate, reaches a maximum and then declines. TotalUtility Quantity

  11. Marginal Utility diminishes with increased consumption, reaches zero satisfaction and then becomes negative. MU Marginal Utility Quantity

  12. To t a l U t i l i t y TU Unit Consumed M a r g I n a l U t I l I t y MU Unit Consumed When Total Utility is at its peak, Marginal Utility is zero. Marginal Utility reflects the change in total utility so it is negative when Total Utility declines. Marginal Utility diminishes with increased consumption, is zero where total utility is at a maximum, and is negative when Total Utility declines.

  13. P1 P2 Q1 Q2 Demand Curve P D Q

  14. Why does • MU = P • explain the downward sloping demand curve?

  15. If you are hungry for a hot dog, how many hot dogs will you buy? Up to where MU = P

  16. Because if MU > P you will buy another hot dog • Why? If MU < P you will not buy that last hot dog

  17. At P1, consume to Q1, since MU > P up to that point, at P2, consume to Q2, etc. P1 P2 MU Q1 Q2

  18. Consumer equilibrium • Now, think about how to allocate income among 2 or more goods or services!

  19. Consumer equilibrium condition • Purchase good X and good Y in amounts such that • MUX = MUy • P x P y Why?

  20. Utility-Maximizing Rule • —Consumer Equilibrium • The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of marginal utility. • The rational consumer must compare the extra utility with its added cost.

  21. U til i t y - Max i m iz i n g w i t h I n co m e of $10 U ni t s P ro d u c t A $1 P ro d u c t B $2 MU or util s MU / $ MU or util s MU / $ Fi r st 10 10 24 12 S econd 8 20 10 8 T hi r d 7 7 18 9 F our t h 6 6 16 8 Fi f t h 5 5 12 6 Si x t h 4 4 6 3 S even t h 3 3 4 2 MU of Product A = MU of Product B Price of A Price of B How many of A and how many of B? What is the combinations of A and B that can be had with $10? Answer: 2 units of A and 4 units of B MU of Product A = MU of Product B Price of A Price of B 8 = 16 $1 = $2

  22. Assume you are not in equilibrium… say that MUx > MUy P x P y What would you do??

  23. Purchase more of X (due to its greater satisfaction per dollar), and less of Y But… more of X reduces MUX and less of Y increases MUY so we are heading back to equilibrium!!

  24. For more than 2 goods, the equilibrium condition becomes….. • MUx/Px = Muy/Py = Muz/Pz • = …….for all goods

  25. When the last dollar spent on each good yields the same marginal utility • In other words, when is your Total Utility maximized?