Consumers and Incentives - Part B

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CONSUMERS AND INCENTIVES

Adjunct Faculty: Fot-Chyi Wong


Lesson Outline

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

In the earlier section, we described the preferences of the


individual, i.e. “what she wants to do”. We now turn to
consider “what she can do” and introduce the concept of
budget constraint.

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

This is called the budget constraint of the individual: her


choice of bundles is constrained by her income.
Budget Constraints
Graphically, we can represent the budget constraint as
shown:
Good Y

If she spends all her income on Y


(I/PY)

If she spends all her income on X

(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

(I0/PX) (I1/PX) (I2/PX) Good X


Budget Constraints: Change in Income
The effect of changing income on the budget line
Good Y Holding prices of X (PX) and Y (PY)
unchanged, when the consumer’s income
decreases, i.e.
(I0/PY)
I4 < I3 < I0
(I3/PY)

A change in income (with prices


(I4/PY) unchanged) causes the budget line
to shift parallel to the original line
without changing the slope.

(I4/PX) (I3/PX) (I0/PX) 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 decreases from 𝑃𝑋0 to 𝑃𝑋1 , BL will rotate
A or pivot out at point B
(I0 / 𝑷𝟎𝒀 )
➢ Feasible consumption set expands by blue area
➢ Slope of BL becomes flatter:
𝑷𝟏𝑿 𝑷𝟎𝑿
|Slope|= <
𝑷𝟎𝒀 𝑷𝟎𝒀

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:

❑ Her preferences, i.e. “what she wants to do”, as


represented by her utility function and indifference curves
❑ Her possibilities, i.e. “what she can do”, as represented

by her budget constraint


We will now put these together to analyze the individual’s or
consumer’s demand, assuming that she wants to maximize
her utility (“happiness”) with her available income or budget –
“what she will do”.
Utility Maximization - “what she wants to do”
The individual would want to move her IC up in north-easterly direction:
Increasing Utility
Good Y

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

“Equal Bang for the Buck” Condition


A

(I/PX) Good X
Optimum Consumption Choice

Extending to N number of goods, therefore:


MU1 MU2 MUN
= =⋯=
P1 P2 PN
This is known as the Equal Marginal Principle, which implies that:
➢ At the optimal allocation, each good consumed yields the same

marginal utility per $ spent on that good


➢ So, each good must have identical marginal benefit (MU) to

marginal cost or price (P) ratio (MU/P)


➢ If different goods have different marginal benefit/price ratio,
one could reallocate consumption among goods and increase
utility. Else, you would not be maximizing utility.
Derivation of the Demand Function
Deriving the Demand Function
We now turn to examine how the familiar downward-sloping demand
curve for a good, say Good X, can be derived from consumer choice
optimization.
P, Price S, Supply Curve

D, Demand Curve

Q, Quantity
Consumer Choice When Price of A Good Changes

Recall that utility maximization subject to


budget constraint yields the optimal
Y
consumption point at A(XA, YA), where I0, 𝑃𝑋0
and 𝑃𝑌0 are initial income and prices of X
(I0/𝑃𝑌0 )
and Y respectively.
What if the price of Good X decreases
from 𝑃𝑋0 to 𝑃𝑋1 , or increases from 𝑃𝑋0 to 𝑃𝑋2 ?

A
YA

IC0

XA (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Changes

A change in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has


become cheaper relative to the other good. This response to
a change in the relative prices or opportunity costs of the
goods is called the substitution effect (SE).

2. When one good in the consumption basket has changed


price, it affects the consumers’ real income or purchasing
power. The change in demand due to this change in real
income or purchasing power is called the income effect (IE).
Consumer Choice When Price of A Good Changes

Opportunity costs of Substitution Consumer


good X decreases Effect buys more X
PX
Falls Consumer is
Income Consumer
better off
Effect buys more X
(Higher real income)

Opportunity costs of Substitution Consumer


good X increases Effect buys less X
PX
Rises Consumer is
Income Consumer
worse off
Effect buys less X
(Lower real income)

(Assuming good X is a normal good.)


Consumer Choice When Price of A Good Decreases

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

Conceptually: ❑ Substitution Effect (SE) is shown as the shift from bundle A


to a hypothetical bundle B along the original indifference
Y curve IC0 assuming the consumer’s real income, and hence
utility, are unchanged.
(I0/𝑃𝑌0 ) ➢ At point B, the consumer's MRS is equated
1
𝑃𝑋
to the new price ratio of the two goods.
𝑃𝑌0
0
|slope| of BL1 =
𝑃𝑋
𝑃𝑌0
➢ SE = (XB – XA)

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

Conceptually: ❑ Income Effect (IE) is shown as the move from bundle B to


the final consumption bundle C on a higher indifference
Y curve IC1 consistent with the increase in real income or
purchasing power, assuming X is a normal good.
(I0/𝑃𝑌0 ) ➢ IE = (XC – XB)

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

Conceptually: ❑ Total increase in quantity of good X following its price


decrease, is: ∆X = SE + IE
Y = (XB – XA) + (XC – XB)
= (XC – XA)
(I0/𝑃𝑌0 )
(Note: Bundle B is a hypothetical construct used to illustrate
SE and IE. We can only observe the consumer’s choices as
bundles A and C, but cannot observe bundle B.)

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

Conversely, when the price of X increases from 𝑃𝑋0 to 𝑃𝑋2 :


❖ budget line BL1 rotates or pivots in along x-axis to BL2
Y
❖ feasible consumption set contracts by shaded area
(I0/𝑃𝑌0 )
❖ original bundle A is no longer affordable
❖ new optimum consumption is bundle C on lower IC2
❖ change in quantity of X = ∆X = (XC – XA)
BL2
2
– negative or decrease
𝑃𝑋
|slope| of BL2 =
𝑃𝑌0

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

Change in quantity of X due to increase in 𝑃𝑋 comprises SE and IE:


Y
❑ Substitution Effect (SE): shown as the shift from bundle A
to a hypothetical bundle B along the original indifference
curve IC0 assuming the consumer’s real income, and hence
(I0/𝑃𝑌0 )
utility, are unchanged.
2
SE = (XB – XA)
𝑃𝑋
|slope| =
𝑃𝑌0
new price ratio B

A
YA

IC0
0
𝑃𝑋
|slope| of BL1 =
SE 𝑃𝑌0
BL1

XB XA (I0/𝑃𝑋0 )
X
Consumer Choice When Price of A Good Increases

Change in quantity of X due to increase in 𝑃𝑋 comprises SE and IE:


Y
❑ Income Effect (IE): shown as the move from bundle B to
the final consumption bundle C on a lower indifference
curve IC2 consistent with the decrease in real income,
(I0/𝑃𝑌0 )
assuming X is a normal good.
2
IE = (XC – XB)
𝑃𝑋
|slope| =
𝑃𝑌0 BL2
new price ratio B
2
𝑃𝑋
|slope| of BL2 =
𝑃𝑌0
A
YA
YC C

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

Change in quantity of X due to increase in 𝑃𝑋 comprises SE and IE:


Y
❑ Hence, total change in quantity of good X is:
∆X = SE + IE
(I0/𝑃𝑌0 ) = (XB – XA) + (XC – XB)
= (XC – XA) – negative

BL2 (Reminder: Bundle B is a hypothetical construct used to


B
illustrate SE and IE. We can only observe the consumer’s
𝑃𝑋2 choices as bundles A and C, but cannot observe bundle B.)
|slope| of BL2 =
𝑃𝑌0
A
YA
YC C

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

 Hence, ceteris paribus, i.e. holding the consumer’s


preferences, income and the prices of other goods
constant,
➢ a decrease in the price of a good leads to an increase in
quantity demanded of this good
➢ an increase in the price of a good leads to a decrease in
quantity demanded of this good
 This inverse relationship is the case for most goods
referred to as normal goods.
Normal Goods, Inferior Goods, Giffen Goods

Impact of A Price Decline on Quantity of Good Demanded


Substitution Effect Income Effect Total Effect
Type of Good
(SE) (IE) (TE)
Normal Increase Increase Increase

Inferior (but not Giffen) Increase Decrease Increase

Giffen Increase Decrease Decrease


Quantity of Good
– 0 +
SE IE
Normal
TE
Inferior (but not Giffen)

Giffen
Normal Goods, Inferior Goods, Giffen Goods

Impact of A Price Decline on Quantity of Good Demanded


Type of Good Substitution Effect Income Effect Total Effect
(SE) (IE) (TE)
Normal Increase Increase Increase

Inferior (but not Giffen) Increase Decrease Increase

Giffen Increase Decrease Decrease


Normal Goods, Inferior Goods, Giffen Goods

Quantity of Good
– 0 +
IE SE
Normal
TE
Inferior (but not Giffen)

Giffen

Impact of A Price Increase on Quantity of Good Demanded


Type of Good Substitution Effect Income Effect Total Effect
(SE) (IE) (TE)
Normal Decrease Decrease Decrease

Inferior (but not Giffen) Decrease Increase Decrease

Giffen Decrease Increase Increase


Normal Goods, Inferior Goods, Giffen Goods

Impact of A Price Decline on Quantity of Good Demanded


Type of Good Substitution Effect Income Effect Total Effect
(SE) (IE) (TE)
Normal Increase Increase Increase

Inferior (but not Giffen) Increase Decrease Increase

Giffen Increase Decrease Decrease

Impact of A Price Increase on Quantity of Good Demanded


Type of Good Substitution Effect Income Effect Total Effect
(SE) (IE) (TE)
Normal Decrease Decrease Decrease

Inferior (but not Giffen) Decrease Increase Decrease

Giffen Decrease Increase Increase


Derivation of Individual Demand Curve

Thus far, we have considered and analyzed the effect of


changes in the price of good X, PX, on the optimum quantity
of good X consumed. We can repeat the analysis for
various prices of good X and arrive at the consumer’s
individual demand for good X.
Individual Demand Curve for Good X
Y Consumer i
M
 Assume that good Y is a composite
IC good (or all other goods) with a
Optimum
Consumption
price of $1, i.e. PY = 1; and the
Bundle price of good X is P, i.e. PX = P.
 Hence, the slope (absolute value) of
the individual’s budget constraint is
X1 thus:
X
P
Slope = P1
PX/PY = P/1 = P
 Given her income of M,
preferences (or tastes) and holding
P1
the price of composite good Y
unchanged at 1, her optimum
consumption quantity of good X at
the initial price of (PX =) P1 is X1 as
shown in the diagram.
X1 X
Individual Demand Curve for Good X
Y Consumer i
M
 As the price of good X, P, declines
IC from P1 to P2 and then P3, i.e.
P1 > P2 > P3
 The individual’s budget constraint
rotates or pivots outward …
 … and her optimum consumption
X1 X 2 X3
X
bundle also changes.
Slope = P1 P2 P3
P
Consumer i’s  The lower diagram plots the
Demand for X consumer’s optimum quantities of good
P1 X consumed against the corresponding
prices of good X, P …
P2  … from which the consumer’s
individual demand curve for good X
P3
can be derived.
Di
X1 X2 X3 X
From Individual Demand to Market Demand
Y Consumer i
M
 Similarly, we can derive the individual
IC
demand curve for consumer 2, D2, and
all other consumers in the economy.
 Adding these individual demand curves
across all consumers then gives us the
P1 > P2 > P3 market demand curve for this good:
Slope = P1 P2 P3 X DM = D1 + D2 + … = ∑ Di
P P
Consumer i’s
Demand for X Market Demand for X

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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• Hope you have learned something useful.
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