ORGANIZATION AND MARKET

ECONOMICS
LECTURE 7 - THEORY OF CONSUMER DEMAND

Prof. THIAGU RANGANATHAN

AGENDA

• BUDGET CONSTRAINTS

• UTILITY MAXIMIZATION

• INCOME EFFECT

• PRICE EFFECT AND DEMAND CURVE

• GIFFEN GOOD
APPROACH
Consumers
maximize
their levels
Opportunity of
• Time, Money, and other Costs satisfaction
resources are scarce
• We make choices in • While we do so, we Markets allow
presence of this scarcity account for opportunity interaction of
costs
the two and
we obtain an
equilibrium
Scarcity
Producers
maximize
their profits

• Consumers have preferences which

follow certain regularities
Consumers
• These preferences are mathematically
maximize their represented using utility and
levels of consumers maximize their utility
satisfaction
• Utility maximization happens subject to
consumer’s budget constraints
BUDGET CONSTRAINTS

 Budget constraint reduces the consumer to

select a bundle of goods that is affordable
140

50 A  25C  3000
120
C  120  2 A
100 BUDGET LINE
 The combinations of bundles the can be 80 OPPORTUNITY SET
bought with the income forms the 60
consumer’s opportunity set/budget set
40

20

0
0 10 20 30 40 50 60 70

 Budget line defines all the combination of

goods that exhaust the consumers’ income
BUDGET CONSTRAINTS

 The maximum affordable quantity of X is

140
60 when the consumer exhausts the
120
50C  25 A  3000 whole income on commodity X
C  120  2 A
100 BUDGET LINE
80

60
 The maximum affordable quantity of Y is
120 when the consumer exhausts the
40
whole income on commodity Y
20

0
0 10 20 30 40 50 60 70

 The slope of the budget line (-PX/PY) is -

2 which represents the Market Rate of
Substitution between goods X and Y
UTILITY MAXIMIZATION

 Consider the optimization problem of a

140
consumer
50 A  25C  3000
120
C  120  2 A  A point F will provide a high utility, but
100 A F that is out of reach for a consumer
80 B because of her/his scarce resources
60
C (income)
40
D  Points A,B, D and E are attainable, but
20 E the consumer can attain a higher utility
0 and choosing any of the points means
0 10 20 30 40 50 60 70
there is an opportunity cost to the
consumer
 Given this, the consumer will choose
point C, where the budget line is tangent
to an indifference curve
UTILITY MAXIMIZATION

 At the optimal point for the consumer,

140
the slope of the budget line and the
120
50 A  25C  3000 slope of the indifference curve are the
C  120  2 A same
100 dC  PA
Slope  
dA PC
80

C
60

40

20  The Marginal Rate of Substitution is thus

0
equal to the Market Rate of Substitution
0 10 20 30 40 50 60 70 MU A PA
MRS  
MU C PC
or
MU A MU C

PA PC
 UTILITY MAXIMIZATION
U ( A, C )  20 AC
50 A  25C  3000
MU A  10 C / A
 At the optimal point for the consumer,
MU C  10 A / C X Y MUX MUY MUX/PX MUY/PY
the slope of the budget line and the
5 110 46.90 2.13 0.94 0.09 slope of the indifference curve are the
10 100 31.62 3.16 0.63 0.13 same
15 90 24.49 4.08 0.49 0.16

20 80 20.00 5.00 0.40 0.20

25 70 16.73 5.98 0.33 0.24  The Marginal Rate of Substitution is thus

30 60 14.14 7.07 0.28 0.28
equal to the Market Rate of Substitution
or Marginal Rate of Transformation
35 50 11.95 8.37 0.24 0.33

40 40 10.00 10.00 0.20 0.40 MU A PA

MRS  
MU C PC
45 30 8.16 12.25 0.16 0.49
or
50 20 6.32 15.81 0.13 0.63
MU A MU C

55 10 4.26 23.45 0.09 0.94 PA PC
INCOME EFFECT
50 A  25C  2000
C  80  2 A
 For normal goods, a change in income will
result in change in amount consumed in the
180 50 A  25C  3000 same direction
160
C  120  2 A

140
50 A  25C  4000
C  60  2 A
120

100
 A reduction in income will shift the budget
80
D line towards left
C
60

40
B

20  An increase in income will shift the budget

0 line towards right
0 10 20 30 40 50 60 70 80 90

 For an inferior good, an increase in income

will be accompanied by a reduction in
consumption
PRICE EFFECT AND DEMAND CURVE
140

120  The budget line will move inwards if the

100
price of a commodity reduces and
move outward if the price of the
80
commodity decreases
60

40  From the price effect, we can derive the

20
demand curve for an individual
consumer. The sum of individual
0
0 20 40 60 80 100 120 140 demands is the market demand
80 80

70 70

60 60

50 50

40 40

30 30

20 20

10 10

0 0
0 20 40 60 80 100 120 140 0 20 40 60 80 100 120 140
PRICE EFFECT AS A SUM OF INCOME AND SUBSTITUTION
EFFECT

NORMAL GOOD GIFFEN GOOD

180  Substitution effect is found by assuming
U ( A, C )  A * C
160 that the individual gets a compensatory
income which will help him maintain the
140
50 A  25C  4243 same utility as before. For any good,
120 substitution effect is negative.
F (42.4,84.9);U (42.4,84.9)  42.4*84.9  60
100
 Income effect is found as the change in
80 consumption due to reduction in this
60
E (60, 60);U (60, 60)  60*60  60
compensatory income. It is also negative
G(30, 60);U (30, 60)  30*60  42.4 for normal goods. For Giffen good, the
40
50 X  25Y  3000
income effect is large and significantly
20
25 A  25C  3000
positive to overcome the substitution
0
effect and reverse its impact.
0 20 40 60 80 100 120 140

Both Substitution and Income Effect

Negative for Price Rise
SUMMARY
140

120
MU A PA
100 MRS  
MU C PC
80
or
60 MU A MU C

40 PA PC
20

0
0 10 20 30 40 50 60 70
80
140
70
120
60
100
50

80
40

60 30

40 20

10
20

0
0 0 20 40 60 80 100 120 140
0 20 40 60 80 100 120 140