Consumers and Incentives - Part B
Consumers and Incentives - Part B
Consumers and Incentives - Part B
PART A PART B
❑ Introduction to Consumer Theory Budget Constraints
➢ Change in Income
❑ Properties of Consumer Preferences
➢ Change in Prices
Utility and Utility Function Optimum Consumption Choice
Indifference Curves & Utility ➢ Utility Maximization
➢ Optimality Condition: “Equal Bang
Marginal Utility & Marginal Rate of
for the Buck”
Substitution
Derivation of the Demand Function
Examples of Utility Function ➢ When Price of A Good Falls
➢ Perfect Substitutes ❖ Substitution and Income Effects
➢ When Price of A Good Increases
➢ Perfect Complements ❖ Substitution and Income Effects
➢ Normal Goods, Inferior Goods,
Giffen Goods
Lesson Outline
PART B
Budget Constraints
➢ Change in Income
➢ Change in Prices
Optimum Consumption Choice
➢ Utility Maximization
➢ Optimality Condition: “Equal Bang for the Buck”
Derivation of the Demand Function
➢ When Price of A Good Falls
❖ Substitution and Income Effects
➢ When Price of A Good Increases
❖ Substitution and Income Effects
➢ Normal Goods, Inferior Goods, Giffen Goods
Budget Constraints
Budget Constraints
Definition:
A budget constraint represents the bundles among which
the consumer may choose given the prices that she faces
and her money.
Budget Constraints
Back in our world of 2 goods, X and Y. If an individual has
income I and the prices of goods X and Y are PX and PY
respectively, then she can choose to consume bundles of (X, Y)
such that the cost of the bundle is at most I, thus:
PX.X + PY.Y ≤ I
(I/PX) Good X
Budget Constraints
The budget line PX.X+PY.Y=I denotes the maximum possible combination
of (X, Y) she can consume. It delineates the X-Y space into affordable (or
feasible) and unaffordable (or infeasible) consumption sets.
Good Y
(I/PY)
unaffordable
affordable
(I/PX) Good X
Budget Constraints
The slope of the budget line is given by:
∆𝐘 𝐈/𝐏𝐘 𝐏𝐗
𝐒𝐥𝐨𝐩𝐞 = =− =−
Good Y ∆𝐗 𝐈/𝐏𝐗 𝐏𝐘
[Note: It’s negative as it is downward-sloping.]
(I/PY)
Or in absolute value terms:
∆𝐘 𝐏𝐗
=
∆𝐗 𝐏𝐘
which is the market rate of
exchange between X and Y, or the
price of X in terms of Y.
(I/PX) Good X
Budget Constraints
Example: Every month, Silas spends a constant $100 of his income on
apples and oranges. If the price of an apple is $1.00 and the price of
an orange is $0.50, his budget line (BL) is as
Good Y
Apples
shown in green.
𝑃𝑜𝑟𝑎𝑛𝑔𝑒 $0.50
✓ Slope of BL =− =− = – 0.5
𝑃𝑎𝑝𝑝𝑙𝑒 $1.00
(I/PY)
⇒ 1 orange = 0.5 apple
✓ Cost of bundle A = ($1x120 + $0.5x60) = $150
120
A
> $100 ⇒ unaffordable
100
✓ Cost of bundle B = ($1x50 + $0.5x30) = $65
< $100 ⇒ affordable
C
✓ Bundles C, D and E are on BL and cost the same
B
50 D amount $100
⇒ just affordable (use up budget)
E
30 60 200 Good X
Oranges
(I/PX)
Budget Constraints: Change in Income
The effect of changing income on the budget line
Good Y Holding prices of X (PX) and Y (PY)
(I2/PY) unchanged, when the consumer’s income
(I1/PY) increases, i.e.
(I0/PY)
I2 > I1 > I0
B
(I0 / 𝑷𝟎𝑿 ) (I0 / 𝑷𝟏𝑿 ) Good X
Budget Constraints: Change in Prices
The effect of changing prices on the budget line
Good Y
Changes in 𝑃𝑋 holding I0 and 𝑃𝑌0 unchanged:
• Budget line (BL) will be anchored at point A.
• If PX increases from 𝑃𝑋0 to 𝑃𝑋2 , BL will rotate
A or pivot in at point B
(I0 / 𝑷𝟎𝒀 )
➢ Feasible consumption set contracts by red area
➢ Slope of BL becomes flatter:
𝑷𝟐𝑿 𝑷𝟎𝑿
|Slope|= >
𝑷𝟎𝒀 𝑷𝟎𝒀
B
(I0 / 𝑷𝟐𝑿 ) (I0 / 𝑷𝟎𝑿 ) Good X
Budget Constraints: Change in Prices
The effect of changing prices on the budget line
Good Y
C hanges in 𝑃𝑌 holding I 0 and 𝑃𝑋
0
unchanged:
• BL will now be anchored at point B.
• BL will pivot out at point A when 𝑃𝑌 decreases
A • feasible consumption set expands as the slope
(I0 / 𝑷𝟎𝒀 )
steepens
• BL will pivot in at point A when 𝑃𝑌 increases
• feasible consumption set contracts as the slope
flattens
B
(I0 / 𝑷𝟎𝑿 ) Good X
Optimum Consumer Choice
Utility Maximization
Up to now, we have learned about the 2 elements of an
individual’s or consumer’s problem, viz:
Good X
Utility Maximization - “what she can do”
However, she is constrained by what she can afford with her income:
Good Y
(I/PY)
feasible
(I/PX) Good X
Utility Maximization - “what she will do”
Hence, she will maximize her utility at consumption bundle A(XA,YA)
where her highest IC is just tangent to her budget line, thus:
Good Y
(I/PY)
A
YA
XA (I/PX) Good X
Optimum Consumption Choice
At the point of tangency at A, the gradient or slope of the IC is the same
as the slope of the budget line.
Recall from our earlier discussion:
Good Y
MUX
➢ |Slope| of IC at A = MRSXY =
MUY
(I/PY)
PX
➢ |Slope| of budget line =
PY
(Note: Strictly, the slopes are negative, but MRS is defined as
equal to the absolute value of the slope, or |slope|.)
A
YA Hence, at point of utility maximization:
MUX PX
=
MUY PY
XA (I/PX) Good X
Optimum Consumption Choice
At any other point on the budget line (BL), such as B or C, the bundle:
o costs the same as bundle A which equals the
Good Y
consumer’s income, but
o provides the consumer less satisfaction or utility, and
(I/P )
o is inferior, or less preferred, to bundle A
Y
(I/PX) Good X
Optimum Consumption Choice
At point B, consumer’s utility is NOT maximized, since:
MUX
MRSXY (= ) = |slope| of IC at point B
MUY
PX
Good Y < |slope| of budget line (= )
PY
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
This implies that, at point B, if the consumer gives up 1 unit of good X:
➢ She would only need α units of good Y to remain
equally satisfied at the same level of utility as bundle B
Good Y 𝑃𝑋
➢ But, at the exchange rate of (given by|slope| of
𝑃𝑌
BL), she will get β units of good Y in exchange
(I/PY) ➢ Since β > α, she is better off exchanging some X for Y
to increase her satisfaction or utility
A
β
α B
B
1 unit
(I/PX) Good X
Optimum Consumption Choice
The consumer will continue to switch from good X to good Y and move
up the BL until she reaches bundle A and attains maximum satisfaction.
Good Y
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
The consumer will continue to switch from good X to good Y and move
up the BL until she reaches bundle A and attains maximum satisfaction.
Good Y
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
The consumer will continue to switch from good X to good Y and move
up the BL until she reaches bundle A and attains maximum satisfaction.
Good Y
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
Similarly, at point C, consumer’s utility is NOT maximized, but this time:
MUX
MRSXY (= ) = |slope| of IC at point B
MUY
PX
Good Y > |slope| of budget line (= )
PY
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
At point C, if the individual gives up 1 unit of good Y:
➢ She would only need δ units of good X to remain
equally satisfied at the same level of utility as bundle C
Good Y 𝑃𝑋
➢ But, at the exchange rate of (given by|slope| of
𝑃𝑌
BL), she will get λ units of good X in exchange
(I/PY) ➢ Since λ > δ, she is better off exchanging some Y for X
to increase her satisfaction or utility
C
C
A
1 unit
(I/PX) Good X λ
Optimum Consumption Choice
The consumer will continue to switch from good Y to good X and move
down the BL until she reaches bundle A and attains maximum
satisfaction.
Good Y
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
The consumer will continue to switch from good Y to good X and move
down the BL until she reaches bundle A and attains maximum
satisfaction.
Good Y
(I/PY)
(I/PX) Good X
Optimum Consumption Choice
Hence, at the optimal consumption point A:
𝑴𝑼𝑿 𝑷𝑿
𝑴𝑹𝑺𝑿𝒀 = =
Good Y
𝑴𝑼𝒀 𝑷𝒀
or
𝑴𝑼𝑿 𝑴𝑼𝒀
(I/P )
Y =
𝑷𝑿 𝑷𝒀
(I/PX) Good X
Optimum Consumption Choice
D, Demand Curve
Q, Quantity
Consumer Choice When Price of A Good Changes
A
YA
IC0
XA (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Changes
Hence, when the price of X declines from 𝑃𝑋0 to 𝑃𝑋1 , the budget line BL1 will
rotate or pivot out along x-axis to BL2, as shown:
Y
With the price decline in X, the individual’s
consumption feasibility set has now expanded
(I0/𝑃𝑌0 ) by the shaded area.
Thus, although her nominal income has not
𝑃𝑋0 changed, her real income has increased.
|slope| of BL1 =
𝑃𝑌0
A
YA
1
𝑃𝑋
|slope| of BL2 =
𝑃𝑌0
IC0
BL1 BL2
XA (I0/𝑃𝑋0 ) (I0/𝑃𝑋1 )
X
Consumer Choice When Price of A Good Decreases
As such, she can move to the higher IC1, and consume bundle C(XC,YC) to
maximize her utility, leading to a net increase in quantity of X = ∆X:
Y
The increase in quantity of X by ∆X = (XC – XA)
can be attributed to:
(I0/𝑃𝑌0 )
❑ Substitution Effect, and
0
❑ Income Effect.
𝑃𝑋
|slope| of BL1 =
𝑃𝑌0
C
YC
A
YA
IC1 𝑃𝑋1
|slope| of BL2 =
𝑃𝑌0
IC0
∆X BL1 BL2
XA XC (I0/𝑃𝑋0 ) (I0/𝑃𝑋1 )
X
Consumer Choice When Price of A Good Decreases
A
YA
B
1
𝑃𝑋
IC0 |slope| = , new price ratio
𝑃𝑌0
SE
BL1
XA XB (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Decreases
C
YC
A
YA
B IC1 𝑃𝑋1
|slope| of BL2 =
𝑃𝑌0
IC0
SE IE
BL1 BL2
XA XB XC (I0/𝑃𝑋0 ) (I0/𝑃𝑋1 )
X
Consumer Choice When Price of A Good Decreases
C
YC
A
YA
B IC1 𝑃𝑋1
|slope| of BL2 =
𝑃𝑌0
IC0
SE IE
∆X BL1 BL2
XA XB XC (I0/𝑃𝑋0 ) (I0/𝑃𝑋1 )
X
Consumer Choice When Price of A Good Increases
A
YA
YC C
IC0
0
𝑃𝑋
|slope| of BL1 =
𝑃𝑌0
∆X IC2 BL1
XC XA (I0/𝑃𝑋2 ) (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Increases
A
YA
IC0
0
𝑃𝑋
|slope| of BL1 =
SE 𝑃𝑌0
BL1
XB XA (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Increases
IC0
0
𝑃𝑋
|slope| of BL1 =
IE SE 𝑃𝑌0
IC2 BL1
XC XB XA (I0/𝑃𝑋2 ) (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Increases
IC0
0
𝑃𝑋
|slope| of BL1 =
IE SE 𝑃𝑌0
∆X IC2 BL1
XC XB XA (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Changes
Giffen
Normal Goods, Inferior Goods, Giffen Goods
Quantity of Good
– 0 +
IE SE
Normal
TE
Inferior (but not Giffen)
Giffen
P1
D1+ D2+…+… = DM
P2
P3
D1 D2 DM=∑Di
X1 X2 X3 X X
Connecting-the-Dots
Giffen Goods:
➢ WSJ - Economists’ Hunt for a Giffen Good Might Have Ended, 16
July 2007
Veblen Goods:
➢ Economist - Luxury - Exclusively for everybody, 13 Sep 2014
➢ WSJ - Soaring Luxury-Goods Prices Test Wealthy's Will to Pay, 02
Mar 2014
➢ WSJ - New iPhone X Tests Economic Theory, 18 Sep 2017
Substitutes and Complements:
➢ Economist - Taxis v Uber - Substitutes or complements, 10 Aug
2015
➢ ST - Pricey food court fare irks diners, 27 Dec 2010
End of Session
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