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MICROECONOMICS 200

MICROECONOMICS 200. CONSUMER BEHAVIOUR PART 2 Read Chapter 3.3, 3.5, 4.1 & 4.2. ASSESSMENT…Correction from Week 1. Class Assignments (weekly) 15 % Mid-Semester Test (May 2) 15% ..covers weeks 1-4; all MC Essay (April 18) 20%

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MICROECONOMICS 200

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  1. MICROECONOMICS 200 CONSUMER BEHAVIOUR PART 2 Read Chapter 3.3, 3.5, 4.1 & 4.2

  2. ASSESSMENT…Correction from Week 1 • Class Assignments (weekly) 15% • Mid-Semester Test (May 2) 15%..covers weeks 1-4; all MC • Essay (April 18) 20% • Final Examination 50%; involves both MC and essay-style questions.

  3. Recap Key Concepts from Week 1: Indifference Curves & Budget Lines • Consumer preferences are modelled using indifference curves and indifference maps • Consumers’ budgets are modelled using budget lines

  4. A E U2 U1 G U0 Indifference Map: Goods Clothing (units) Direction of ___________ satisfaction increasing • Indifference maps: • Comprise a set of indifference curves E is preferred to A. A is preferred to G. Food (units)

  5. A MRSF for C = - C/F = 6 -6 B 1 MRSF for C = - C/F = 2 -4 D 1 E -2 G -1 1 1 Recap Key Concepts from Week 1: Slope of Indifference Curve Clothing (units) 16 SLOPE OF INDIFFERENCE CURVE 14 12 10 So MRS is represented by the absolute value of slope of the indifference curve 8 6 4 2 1 2 3 4 5 Food (units)

  6. L2 L1 L3 Effects of Price Changes A decrease in the price of food rotates the budget line outward. Clothing (units) An increase in the price of food rotates the budget line inward. Food (units)

  7. L2 L1 L3 Effects of Income Changes An increase in income is shown by a parallel outward shift in the budget line Clothing (units) A decrease in income is shown by a parallel inward shift in the budget line 80 60 40 20 Food (units) 0 40 80 120 160

  8. Recap Key Concepts from Week 1:Slope of Budget Line • Assume income of $80/week, price per unit of food is $1 and price per unit of clothing is $2 • I = $80 • PF = $1 • PC = $2 • Budget line is PFF + PCC = I • Using the formula1F + 2C = 80 Slope = C/F or - PF/PC = -1/2 Ratio of Price of F to Price of C; OR Relative Price of F to C So Relative Price is represented by the slope of the budget line

  9. Recap Key Concepts from Week 1: Indifference Curves & Budget Lines • Consumer preferences are modelled using indifference curves • MRS (F for C) = Absolute value of the slope of indifference= -C/F • Consumers’ budgets are modelled using budget lines • Relative Price of F to C= Slope of budget line = -PF/PC

  10. Recap Key Concepts from Week 1: Consumer Choice Theory • Different consumers prefer different goods  • Consumers have limited incomes to spend  • Consumers’ choices about consumption reflect both their preferences and their budget constraints Consumer preferences Budget constraint Consumer choice

  11. This Week’s Learning Outcomes • Understand the traditional theory’s explanation of how consumers make choices • Trace the effects of price changes from consumer choice to the demand curve • Trace the effects of income changes from consumer choice to the demand curve • Gain an understanding of different types of goods demanded by consumers • Examine the effects of price changes in terms of substitution and income effects

  12. Consumer Choice: Maximising Consumer Satisfaction • Traditional theory assumes that consumers are rational, self-interested maximisers. • Consumers are assumed to choose combinations of goods and services (market baskets) that: • maximise their satisfaction (utility); & • make full use of their budgets • For example, suppose I have$500and I get to choose among 3 market baskets: A is unaffordable B is affordable but does not make full use of budget D is affordable & makes full use of budget The rational consumer chooses D over A & B.

  13. However, A is unaffordable (ABOVE budget line). B is affordable but does not make full use of budget (BELOW budget line) D, G & H are all affordable & make full use of budget (ON budget line) G A B D U1 U2 U3 H 25 50 100 Food (units) Consumer Choice: Maximising Consumer Satisfaction U1 gives the greatest satisfaction, followed by U2, and then U3 Clothing (units) 100 75 PLUS, D is on higher indifference curve than G or H 50 Rational consumer chooses D 25 0 75

  14. Question on Maximising Consumer Satisfaction The diagram brings together Grace’s budget line and indifference map. The two goods are Big Macs and orders of french fries. Which point maximizes Grace’s satisfaction? A. 11 orders of french fries B. 11 Big Macs C. 7 Big Macs & 4 orders of fries D. 4 Big Macs & 7 orders of fries E. None of the above Big Mac B 11 C 7 D 4 Easy question from a past year test which most students got right. Feedback A 11 0 4 7 French fries

  15. Consumer Choice: Maximising Consumer Satisfaction • To fully understand the traditional theory, we need to delve more deeply into the meaning of MRS and the significance of the tangency point shown on the last diagram

  16. 20 40 80 Food (units) Consumer Choice:Maximising Consumer Satisfaction Consumer satisfaction is maximised at D, where the Slope of indifference curve = Slope of budget line Clothing (units) Recall MRSis represented by the slope of indifference curve 40 Recall RELATIVE PRICE is represented by the slope of budget line 30 Consumer satisfaction is maximised at D when: MRS = RELATIVE PRICE D 20 MRS (F for C) = PF/PC MRS (C for F) = PC/PF Point of tangency 10 U2 0 60

  17. Now for some more details on MRS • Recall all market baskets on the same indifference curve give the same level of utility • Also recall that the slope of indifference curves conveys information on the amount of value (utility) consumers get from the different goods • A utility function gives a numerical interpretation of these ideas • If a person’s utility function is U(F,C) = F + 2C • 8 units of F & 3 units of C gives her utility of U(F,C) = 8 + 2(3) = 14

  18. Another really important concept! Consumer Choice & Marginal Utility • Marginal utility (MU) measures the additional (marginal)satisfaction obtained from consuming 1 additional unit of a good. • It is the key measure of the consumer’s valuation of different commodities • Using the example of U(F,C) = F + 2C 2 2

  19. Consumer Choice & Marginal Utility Comparing the MU of two different goods gives us MRS MUF/MUC =MRS (F for C) Logic: The more utility I get from a good, the more I’m willing to give up to get more of it If I derive 5 times as much utility from an extra unit of food as I do from an extra unit of clothing, MUF/MUC = 5 then I should be willing to give up 5 units of clothing to get an additional unit of food. MRS (F for C) = 5

  20. D U2 20 40 80 Food (units) Consumer Choice: 3 Formulas Clothing (units) Consumer satisfaction is maximised at D, where MRS (F for C) = PF/PC 40 Therefore MUF/MUC = PF/PC 30 Therefore MUF/PF= MUC /PC 20 Point of tangency 10 0 60

  21. Consumer Choice: Understanding the Key Formula MUF/PF= MUC /PC MUF/MUC = PF/PC or This tells us the extra value the consumer will get from spending $1 extra on food This tells us the extra value the consumer will get from spending $1 extra on clothing When the ratios are equal (i.e. At the point of tangency) the consumer won’t increase her utility by spending more on clothing and less on food or vice versa

  22. D U2 20 40 80 Food (units) Consumer Choice: Understanding the Key Formula Clothing (units) Consumer satisfaction is NOT maximised at C, because MRS (F for C) ≠ PF/PC 40 Therefore MUF/MUC ≠PF/PC 30 Therefore MUF/PF≠MUC /PC 20 10 C U1 0 60

  23. Consumer Choice: Understanding the Key Formula At point C the IC is flatter than the budget line, so

  24. Consumer Choice: Understanding the Key Formula MUF/PF<MUC /PC MUF/MUC <PF/PC or Suppose at point C I’m getting 4 units of value for each $1 I’m spending on clothing and 1 unit of value from each $1 I’m spending on food. If I spend $1 less on food and $1 more on clothing my U will increase by 3 ☺☺☺ This tells us the extra value the consumer will get from spending $1 extra on clothing This tells us the extra value the consumer will get from spending $1 extra on food When the ratios are NOT equal the consumer CAN increase her utility by spending more on clothing and less on food or vice versa.

  25. Effects of Price Changes in MILK …on Consumer Choice “Coles instigated a price war in January by slashing the price of its no-name milk to $1 a litre, forcing Woolworths, Aldi and Franklins to also reduce prices.…. The no-name milk now accounts for 51 per cent of all milk sales and 72 per cent of full-cream milk sold in the country's supermarkets, according to the group. That is up from 25 per cent in the late 1990s.” • Annabel Hepworth, Milk wars 'could cost suppliers $730m‘,The AustralianMarch 04, 2011

  26. A U1 B PM=$1 PM=$2.50 U2 PM=$2 Effects of Price Changes …. on Consumer Choice Assume: I = $50, PM = $2.50, $2, $1 Other goods (units) 1. PM decreases: Budget line rotates outwards along milk axis 2. One utility-maximisation point per budget line. D 3. Trace utility-maximisingbasket at each price of milk to get Price consumption curve (PCC) U3 Milk (cartons)

  27. Price Consumption Curve This joins up the utility maximising points as one price changes while holding income and the other price constant.

  28. 9 7 6 15 10 2 Effects of Price Changes …. on Individual Demand for Milk 4. Derive demand schedule for MILK using PCC Other goods (units) A U1 D U3 B PM=$1 PM=$2.50 U2 PM=$2 Milk (cartons)

  29. Price of MILK A $2.50 B $2 D $1 Individual Demand Curve Milk (cartons) 2 15 10 Effects of Price Changes …. on Individual Demandfor Milk 5. Draw demand curve for MILK using demand schedule

  30. Price of MILK A $2.50 B $2 D $1 Milk (cartons) 2 15 10 Effects of Price Changes …. on Individual Demandfor Milk Increasein price = Movement updemand curve Decreasein price = Movement downdemand curve

  31. Income Consumption Curve This joins up the utility maximizing points as income changes, while holding all prices constant.

  32. Clothing (units) I=$30 I=$20 D U3 U2 I=$10 B U1 A Food (units) Effects of Income Changes …. on Consumer Choice Assume: PC = $2, PF = $1, I = $10, $20, $30 1. Income increases: Budget line shifts outwards in a parallel manner 2. One utility-maximisation point per budget line 3. Trace utility-maximisingbasket at each income level to get Income consumption curve (ICC)

  33. I=$30 I=$20 7 D U3 5 U2 B I=$10 3 U1 A 4 10 16 Effects of Income Changes …. on Individual Demand for Food 4.Derive demand schedulefor FOOD Using ICC Clothing (units) Food (units)

  34. D A B $1.00 D3 D2 D1 4 10 16 Effects of Income Changes …. on Individual Demand for Food 5. Draw demand curve for FOOD using demand schedule Price of food Food (units)

  35. A B D $1.00 D3 D2 D1 4 10 16 Effects of Income Changes …. on Individual Demand for Food Price of food Increasein income = Shift to the right by demand curve Decreasein income = Shift to the left by demand curve Food (units)

  36. ICC C 15 U3 10 B U2 5 A U1 16 10 4 Normal goods Steak (units) • Consumer wants more steak as income increases: Steak is a normal good • Consumer also wants more designer clothes as income increases: Designer clothes are normal goods • Normal good: You buy more when your income increases. Designer clothes (units)

  37. C 15 U3 6 Inferior goods Between A & B: • Both steak & hamburger are normal goods. You buy more of both as your income increases. Between B & C: • Steak is still a normal good. • Hamburgers become an inferior good – consumer wants fewer hamburgers (106) as income increases. • ICC: • upward-sloping between A & B, backward-bending between B & C. Steak (units) B 9 U2 5 A U1 Hamburger (units) 10 4

  38. Income ($ per month) 30 20 10 Steak (units per month) 4 8 12 16 Engel Curves Engel curves relate the quantity of a good to INCOME. Engel curves slope upward for normal goods.

  39. Income ($ per month) 30 Inferior 20 Normal 10 Hamburger (units per month) 4 8 12 16 Engel Curves Engel curves are backward bending for inferior goods.

  40. Income and Substitution Effects • A change in price can be broken down into 2 effects: • Substitution Effect • Income Effect

  41. Substitution Effect • Occurs because the RELATIVE PRICE of a good changes • Example: when the price of apples increases, apples become more expensive relative to pears • You buy fewer apples but more pears, that is, you SUBSTITUTE pears for apples to keep your UTILITY CONSTANT • Definition: The substitution effect is the change in a good’s consumption associated with a change in the __________________ of the good, with the level of ____________________. RELATIVE PRICE UTILITY CONSTANT

  42. Finding the Substitution Effect • Following a price change, move the budget line back until it is just tangent to the original IC. The SUBSTITUTION EFFECT is the movement around the original IC.

  43. D B U2 L2 Substitution Effect When Price Falls: Graphical Representation Price of food decreases: Budget line rotates outward from L1 to L2. Clothing (units) Recall Substitution effect: Change in relative price; Utility constant Change in relative price  Change in slope of original budget line L1 A Utility constant Stay at original indifference curve U1 The substitution is F1E (move from A to D). Substitution effect U1 L1 F2 F1 E Food (units) Total effect

  44. Income Effect • Occurs because consumers experience a change in REAL PURCHASING POWER when price changes • Example: when the price of apples increases, your overall ability to purchase goods decreases. • Definition: The income effect is the change in a good’s consumption brought about by a change in ___________________________. REAL PURCHASING POWER

  45. Finding the Income Effect • The Income effect is the movement between the ARTIFICIAL optimum used to find the Substitution effect, and the consumer’s new utility maximising position.

  46. D B U2 Income effect L2 Income Effect When Price Falls: Graphical Representation Recall Income effect: Change in overall real purchasing power Clothing (units) Change in real purchasing power  Parallel shift from dotted red line to budget line L2 The income effect is EF2 (move from D to B). A TIP: The dotted red line must ALWAYS be PARALLEL to L2. Substitution effect U1 L1 F2 E F1 Food (units) Total effect

  47. D B U2 L2 F1 E Income Effect When Price Falls: Normal Good Clothing (units) This graph shows that food is a NORMAL good. Recall: A normal good is a good you buy MORE of as your income increases. A Consumer moves from D to B, so the units of food INCREASE from E to F2 Income effect Substitution effect U1 L1 F2 Food (units)

  48. D B Income effect U2 Substitution effect L2 F1 E F2 Income Effect When Price Falls: Inferior Good This graph shows that food is an INFERIOR good. Clothing (units) Recall: An inferior good is a good you buy LESS of as your income increases. Consumer moves from D to B, so the units of food DECREASE from E to F2 A U1 L1 Food (units)

  49. D Income effect Substitution effect F2 F1 E Income Effect When Price Falls: Giffen Good Clothing (units) This graph shows that food is a GIFFEN good. A Giffen good is a special case of an inferior good. B U2 A The income effect is so large that it is greater than the substitution effect. U1 L2 L1 Food (units)

  50. Summary of Price Falls • Normal Good Income effect reinforces Substitution effect. • Inferior Good, Not Giffen Income effect offsets Substitution effect but does not dominate. • Inferior Good, Giffen Income effect offsets Subsitution effect and dominates.

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