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Session 4

The document discusses concepts related to consumer demand and utility maximization including: 1. Marginal utility, the utility function, and the law of diminishing marginal utility. 2. How consumers choose bundles that maximize their utility given budget constraints. 3. How changes in prices and income affect consumer demand through substitution and income effects. 4. The difference between compensated and uncompensated price changes and how they impact demand through substitution and income effects.

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Akshit Gaur
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76 views

Session 4

The document discusses concepts related to consumer demand and utility maximization including: 1. Marginal utility, the utility function, and the law of diminishing marginal utility. 2. How consumers choose bundles that maximize their utility given budget constraints. 3. How changes in prices and income affect consumer demand through substitution and income effects. 4. The difference between compensated and uncompensated price changes and how they impact demand through substitution and income effects.

Uploaded by

Akshit Gaur
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Best choice points and

demand curves
Marginal Utility
• The change in the consumer’s utility resulting from the addition of a
very small amount of some good, divided by the amount added.
• If is the tiny change in the amount of a good X and is the resulting
change in the utility value, then the marginal utility of X, written , is
Utility function for a single good
Law of diminishing marginal utility
• Principle that as more of a good is consumed, the consumption of
additional amounts will yield smaller additions to utility.
Marginal Rate of Substitution (revisited)
• The marginal rate of substitution for any good, call it X, with any other
good, call it Y, equals the ratio of the marginal utility of X to the
marginal utility of Y. In mathematical terms,
Some special utility functions
• Perfect substitutes:
• Perfect complements:
• Cobb-Douglas:

• Quasi-linear:
Budget constraint
• A consumer’s income consists of the money he receives during some
fixed period of time such as an hour, a day, a month, or a year.

• Budget constraint (or budget set): A budget constraint identifies all of


the consumption bundles a consumer can afford over some period of
time.
Budget line
• A budget line shows all of the consumption bundles that just exhaust
a consumer’s income.
• Let be a consumption bundle and
be the price vector associated with the consumption bundle.
Suppose is the income.
The budget set is
The budget line is
Budget constraint for two goods
Change in income
Change in prices
Utility Maximization
•.
Under monotonicity of preferences, .

• Interior solution
• A bundle on the budget line satisfies the tangency condition if, at that bundle,
the budget line lies tangent to the consumer’s indifference curve.
• For two goods:
• Boundary solution
Choosing among the affordable bundles
Price-consumption curve
• The price-consumption curve shows how the best affordable
consumption bundle changes as the price of a good changes, holding
everything else fixed.
Individual demand curve
• An individual demand curve describes the relationship between the
price of a good and the amount a particular consumer purchases,
holding everything else fixed (including the consumer’s income and
preferences, as well as all other prices).
Income-consumption curve
• The income-consumption curve shows how the best affordable
consumption bundle changes as income changes, holding every- thing
else fixed.
Engel curve
• The Engel curve for a good describes the relationship between
income and the amount consumed, holding everything else fixed
(including prices and the consumer’s preferences).
Determining consumer’s preferences
• The revealed preference approach is a method of gathering
information about consumers’ preferences by observing their actual
choices.
• One consumption bundle is revealed
preferred to another if the consumer
chooses it when both are available.
Determining consumer’s preferences
Dissecting the effects of a price change
When the price of a good increases, two things happen:
1. That good becomes more expensive relative to all other goods.
Consumers tend to shift their purchases away from the more
expensive good and toward other goods.
2. The consumers’ purchasing power declines. A rupee doesn’t buy as
much as it once did. Because consumers can no longer afford the
consumption bundles they would have chosen if the price hadn’t
risen, they are effectively poorer and must adjust their purchases
accordingly.
Compensated and uncompensated price
changes
• A compensated price change consists of a price change and an
income change which, together, leave the consumer’s well- being
unaffected.
Effect of a compensated price change =
Effect of an uncompensated price change + Effect of providing compensation

• An uncompensated price change consists of a price change with no


change in income.
Compensated and uncompensated price
changes
Substitution and income effects
• The effect on consumption of a compensated price change is known
as the substitution effect of a price change.

• The effect on consumption of removing the compensation after


creating a compensated price change is known as the income effect of
a price change.

• Price effect = Substitution effect + Income effect


Substitution and income effects
Why Do Demand Curves Usually Slope
Downward?
• Substitution effect: An increase in the price of a good causes the
consumer to substitute away from it, reducing demand, and a
reduction in the price of a good causes the consumer to substitute
toward it, raising demand.
• If a good violates the Law of Demand, the explanation must therefore
involve income effect.
Dissecting the effects of a price fall for a
Giffen good

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