The Demand Side of the The Demand Side of the Market Market - PowerPoint PPT Presentation

Econ Dept, UMR Presents The Demand Side of the The Demand Side of the Market Market

Starring Starring N Utility Theory N Consumer Surplus N Elasticity

Featuring Featuring The MU/ P Rule N The MU/ P Rule N The Meaning of Value N The Meaning of Value N Four Elasticities: N Four Elasticities: N Price Elasticity of Demand O Price Elasticity of Demand O O Income Elasticity Income Elasticity O Cross Price Elasticity O Cross Price Elasticity O O Price Elasticity of Supply Price Elasticity of Supply O The Elasticity-TR relationship N The Elasticity-TR relationship N

In Three Parts In Three Parts Consumer Choice Theory Consumer Choice Theory Consumer Surplus Consumer Surplus Elasticity Elasticity

Part 1 Consumer Choice Theory Consumer Choice Theory Income/ Substitution Effects Income/ Substitution Effects Utility Theory Utility Theory

Assumptions underlying the Assumptions underlying the Consumer choice model: Consumer choice model: N Consumers buy competitively, that is Consumers buy competitively, that is N they can buy as much as they want at a they can buy as much as they want at a given price given price N Consumers have limited money Consumers have limited money N incomes and sufficient information to incomes and sufficient information to make informed choices make informed choices N Consumers are rational Consumers are rational N N Consumers seek to maximize their total Consumers seek to maximize their total N utility or satisfaction utility or satisfaction

Consumers Have to Choose Consumers Have to Choose What They Want With Their What They Want With Their Limited Incomes Limited Incomes ? ? ? ? ? ?

Hot Links Hot Links N USADATA USADATA N Jump to USADATA and Click on “Free Examples” to see some data on your buying patterns

Review -- the determinants of Review -- the determinants of consumer demand (PINTE): consumer demand (PINTE): N P P: The : The price of the product price of the product, and the , and the N prices of substitutes and complements prices of substitutes and complements available to the consumer available to the consumer N I I: The : The income income available to the available to the N consumer consumer N N N: The : The number number of consumers of consumers N N T T: The consumer’s : The consumer’s tastes tastes and and N preferences preferences N E E: The consumer’s : The consumer’s expectations expectations about about N future income, wealth, and prices future income, wealth, and prices

Basic Demand Theory Basic Demand Theory N Law of Demand - The rule that Law of Demand - The rule that N consumers buy more at low prices than consumers buy more at low prices than they do at high prices. they do at high prices. N The Law may be argued from an The Law may be argued from an N analysis of: analysis of: O The Income/ Substitution Effect The Income/ Substitution Effect of a Price of a Price O Change, or Change, or O Utility Theory Utility Theory - A theory of consumer - A theory of consumer O behavior in which people buy goods based behavior in which people buy goods based on the satisfaction they expect to derive on the satisfaction they expect to derive from those goods. from those goods.

First, We’ll Look at the Income First, We’ll Look at the Income and Substitution Effect of a and Substitution Effect of a Price Change Price Change N Price changes affect consumers in two Price changes affect consumers in two N ways: ways: : Consumption changes Income effects : Consumption changes O Income effects O because purchasing power changes. because purchasing power changes. : Consumption Substitution effects : Consumption O Substitution effects O changes because opportunity costs change. changes because opportunity costs change.

Income Effect of a Price Change Income Effect of a Price Change N When the price of a product When the price of a product falls falls, a , a N consumer has more more purchasing power purchasing power consumer has with the same amount of income with the same amount of income N When the price of a product When the price of a product rises rises, a , a N consumer has less less purchasing power with purchasing power with consumer has the same amount of income the same amount of income N More purchasing power will More purchasing power will increase increase the the N demand for normal normal goods and goods and decrease decrease demand for the demand for inferior inferior goods goods the demand for

Normal vs Inferior vs Giffen Normal vs Inferior vs Giffen Goods Goods N Normal Goods Normal Goods - Those that consumers buy - Those that consumers buy N more of as their real incomes rise and less of more of as their real incomes rise and less of as their real income falls as their real income falls N Inferior Goods Inferior Goods - Those goods consumers buy - Those goods consumers buy N more of as their income falls and less of as more of as their income falls and less of as their income rises their income rises N Giffen Goods Giffen Goods - Those - Those inferior inferior goods with an goods with an N income effect that moves in the same income effect that moves in the same direction as price and for which the income direction as price and for which the income . effect is larger than the substitution effect . effect is larger than the substitution effect

Substitution Effects of a Price Substitution Effects of a Price Change Change N When the price of a product When the price of a product falls falls, that , that N product becomes more more attractive attractive product becomes relative to potential substitutes relative to potential substitutes N When the price of a product When the price of a product rises rises, that , that N product becomes less less attractive relative attractive relative product becomes to potential substitutes to potential substitutes N The substitution effect implies the The substitution effect implies the N demand curve will be downward sloping demand curve will be downward sloping

Income vs. Substitution Effect Income vs. Substitution Effect N Income Effect Income Effect - The change in quantity - The change in quantity N demanded of a good due to a change in real demanded of a good due to a change in real income caused by a change in the price of a income caused by a change in the price of a good good N Substitution Effect Substitution Effect - The change in the quantity - The change in the quantity N demanded of a good resulting from a change in demanded of a good resulting from a change in its price relative to the price of other goods its price relative to the price of other goods N Usually, Usually, normally normally,the two effects work ,the two effects work N together--increase in Q D when P falls and together--increase in Q D when P falls and decrease in Q D when P increases decrease in Q D when P increases

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of a Normal Good Fall in Price of a Normal Good Income Real Income Increases Effect Substitution Effect Price Falls Q D Increases P D Q/t

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of an Inferior Good Fall in Price of an * Good Inferior * * Inferior, but not a Giffen Good Income Real Income Increases Effect Q D Decreases Price Falls S u b S u b s s t t i t u t i o i t u t i o n n E f f e c t Q D Increases P D Q D Increases Total Effect = Q/t

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of a Giffen Good Fall in Price of a Giffen Good Income Real Income Increases Effect Q D Decreases Price Falls S u b S u b s s t t i t u t i o i t u t i o n n E f f e c t Q D Increases P D Q D Decreases Total Effect = Q/t

Summary: The Law of Demand and the Income - Substitution Effect N Both effects work to explain the law of Both effects work to explain the law of N demand demand N Only in the case of inferior goods is an Only in the case of inferior goods is an N upward sloping demand possible upward sloping demand possible N Even with inferior goods, the substitution Even with inferior goods, the substitution N effect will outweigh the income effect unless effect will outweigh the income effect unless O the good is strongly inferior and occupies a large the good is strongly inferior and occupies a large O portion of a person’s budget portion of a person’s budget O the market is dominated by persons for whom the the market is dominated by persons for whom the O good is a Giffen good good is a Giffen good N Economists are still looking for a Giffen good Economists are still looking for a Giffen good N

Now, lets look at the law of Now, lets look at the law of demand and consumer demand and consumer choice within the context of choice within the context of Utility Theory Utility Theory N We need to establish some basic We need to establish some basic N concepts concepts O The budget constraint The budget constraint O O Total and Marginal Utility Total and Marginal Utility O O The common sense of the MU/ P rule The common sense of the MU/ P rule O

Budget Constraint Budget Constraint The limits imposed on N The limits imposed on N consumer choices by income, consumer choices by income, wealth, and product prices wealth, and product prices