Perloff Reference Chapters: Chapter 4: pp. 92-105, Chapter 5: pp.

112-128

Agenda
Consumer Equilibrium
Change in Equilibrium Income and Substitution Effects Demand Tastes and Preferences Affects on Demand Consumer Surplus

Consumer Equilibrium
Consumer equilibrium is comprised of two concepts: The utility function The budget constraint Consumer equilibrium can be defined as a

consumption bundle that is feasible given a particular budget constraint and maximizes total utility.

Consumer Equilibrium Cont.

If there was no budget constraint, a person would consume each good to the point where marginal utility of consumption for each good is zero.
Why?

Given a budget constraint, the consumer maximizes total utility by consuming a bundle that is feasible.
A feasible bundle is one that lies either on or inside the

budget constraint.

Consumer Equilibrium Cont.

In graphical terms, consumer equilibrium is defined as

the point where the highest utility function touches the budget constraint.

Consumer Equilibrium Example

Suppose we have the following utility function:
U = u(x1,x2) = x1 * x2 Where x1 is equal to the number of hotdogs consumed Where x2 is equal to the number of sodas consumed

Suppose we have the following budget constraint:

I = p1*x1 + p2*x2 Where pi is equal to the price of hotdogs consumed Where pj is equal to the price of sodas consumed

Consumer Equilibrium Example Cont.

Now consider that you have a price of hotdogs equal to

$2 and a price of soda is a $1. Also suppose that our income is $10. Examine the different indifference curves of U = 1, U=12.5, and U = 25

Consumer Equilibrium Cont.

x2
10

5 1 1 2.5 5

U = 25 U = 12.5 U=1 x1
8

Consumer Equilibrium Cont.

Intuitively what we have done in the graph is equate

the tradeoff from prices to the tradeoff in utility.

I.e., (p2/p1) = (MU2/MU1)

Where p2 is the price of good 2 and p1 is the price of good 1 Where MU2 is the marginal utility of consuming good 2 and MU1 is the marginal utility of consuming good 1

Consumer Equilibrium Cont.

(p2/p1) = (MU2/MU1) can be rewritten as:
(MU2 / p2) = (MU1 / p1) This says that you are normalizing the change in utility

by the price of the good and then equating it to the normalized marginal utility of the other good.

Another way to look at this is to say that the marginal utility derived from the last dollar spent for each good is equal. What happens if one side is greater than the other?
10

Changes in Equilibrium
There are many things that can change consumer equilibrium. The major two items that we will examine that can change consumer equilibrium, ceteris paribus:
Income
Price of each good

Note: Ceteris paribus means that we hold

everything else fixed.

11

Mathematical Side Note on Ceteris Paribus

There are many things that enter our utility function which we can represent with the following utility function:
U = u(x1, x2, x3, , xn)

When we say that we want to examine utility with respect to x1 and x2, ceteris paribus, what we are saying is that we hold constant the values for all

other goods.

12

Mathematical Side Note on Ceteris Paribus Cont.

Mathematically, we can represent holding things

constant in the following two manners:

U = u(x1, x2; x3, , xn) or U = u(x1, x2| x3, , xn)

Where it is understood using this notation that goods x3 through xn are held at some constant level.

13

Change in Equilibrium Example

Suppose Dr. Hurley is consuming a basket of goods

that only has two items, chips and soda. Assume for the moment that the price is held constant for chips at $1.00 and the price for soda is held constant at $1.00.

14

Change in Equilibrium Example Cont.

Also assume that Dr. Hurley has $10 for this basket of

goods and his utility function is represented by U = u(soda, chips) = soda * chips. What is Dr. Hurleys initial consumer equilibrium?

15

Change in Equilibrium Example

Mathematically we can represent Dr. Hurleys problem

as the following:
Dr. Hurleys utility function:

U = u(x1, x2) = x1 * x2 M = p1*x1 + p2*x2 10 = 1*x1 + 1*x2 Where x1 is the quantity of soda consumed Where x2 is the quantity of chips consumed

Dr. Hurleys budget constraint:

16

Change in Equilibrium Example

Consumption of Chips
10

5 U = 25 1 1 5 10
17

Question
How did Dr. Hurley know that consuming 5 chips and

5 sodas will maximize utility?

He used advance math that you will learn in Ag Bus 313? But there is another way you can find the answer.

18

Graphically Finding the Maximum Utility

To find the maximum utility we can make the following argument:
We know that are maximum utility point must lie on the

budget line assuming all the consumption goods are desirable and we are non-satiated, i.e.,utility is always increasing. This being the case we can examine the points on the budget line to see which provides the highest utility. Once we have found the maximum utility on the budget curve, we can hold our utility fixed and draw the utility function.
19

Graphically Finding the Maximum Utility

10 = x1 + x2, U = u(x1,x2) = x1 * x2
Consumption of x1 0 Consumption of x2 10 Total Utility from consumption 0 = 0 * 10

1
2 3 4

9
8 7 6

9=9*1
16 = 2 * 8 21 = 3 * 7 24 = 4 * 6

5
6 7 8

5
4 3 2

25 = 5 * 5
24 = 6 * 4 21 = 7 * 3 16 = 8 * 2

Maximum

20

Change in Equilibrium Example Cont.

What happens if we change the price of soda from $1 to

$2 holding the price of the chips constant. What happens if we change the price of soda from $1 to $0.50 holding the price of the chips constant.

21

Change in Equilibrium Example Cont.

Consumption of Chips
10

5
U = 12.5

U = 50 U = 25

2.5

10

20
22

Observations on Changing Equilibrium

Coincidently, the consumption of chips did not change.
This is a property of the function we used, it is not

always true.

The line/curve that connected all three equilibrium points is considered a price consumption curve.
This curve relates the quantity of chips and soda

consumed when changing the price of soda.

23

Observations on Changing Equilibrium Cont.

As price went down for soda, more was consumed and

when price went up for soda less was consumed. There are two effects at work when price changes:
The income effect The substitution effect

24

Income and Substitution Effects

Substitution Effect It is the change in the quantity consumed due to a change in the price of the good, while holding other prices for goods constant and utility constant. Income Effect It is the change in the quantity consumed due to a relative increase in a change of income while holding prices constant.

25

Graphical Example
Assume that the price for soda has decreased.
To find the substitution effect graphically, we examine what quantities would be consumed if the consumer had to stay on her original indifference curve facing the new prices.
This is equivalent to taking a parallel line to the new

budget line and setting it tangent, i.e., just touching at one point, to the old utility level.

26

Quantity of Chips

Original consumption level

Original Budget line

New consumption level

I2 I1 New Budget Line Quantity of Soda

Substitution Effect

Income Effect

27

Notes on Income and Substitution Effects

The total effect of a price change is the summation of the substitution and income effect.
The substitution and income effect can work in opposite direction of each other. The income effect defines whether the good is an inferior good or a normal good.

28

Inferior and Normal Goods

A normal good can be defined as a good whose

consumption has a positive correlation with the income effect. An inferior good can be defined as a good whose consumption has a negative correlation with the income effect.

29

Deriving Demand
Price of Soda

By changing the price of

Quantity Demanded of Soda 10 5 2.5

soda and examining the new equilibrium point, we can derive the demand curve for soda for an individual. Summarizing the changing equilibrium example gives the following demand schedule for soda:

$0.50 $1.00 $2.00

30

Graphing the Demand Schedule

Price of Soda
$2.00

2.5 5 10

$1.00 $0.50

Quantity of Soda
31

Deriving Demand Cont.

Now suppose we change the price for soda on a continuous basis.
Instead of points on

Demand curve for soda

the graph, you would begin to see a curve like the following:

32

Notes on Demand
We have seen that using the idea of a budget

constraint and utility function, we can derive a persons demand schedule or curve.
A demand schedule is a table that shows the relationship

between the quantity demanded of a good and its corresponding price.

33

Notes on Demand Cont.

When we derived demand, we only change the price of

the good we were investigating and the change in the quantity demanded for the good.
Prices of the other good(s) and income were held fixed.

Any other variable that might affect the utility function

were held fixed also.

34

Notes on Demand Cont.

We can mathematically represent demand for good i as the following:
D(pi) = d(price of good i| price of all other goods and

income) D(pi) = d(pi| p1, p2, , pi-1, pi+1, , pn, M)

Where d() is a functional relationship that maps prices to quantities. pi is the price of good i pj for j = 1,2, , i-1, i+1, , n are the prices of all other good except good i M is the persons income.

35

Other Demand Determinants

Beside the price of the good, there are three other

major items that affect the demand curve:

Income (M) Prices of other goods (pj)

Tastes and preferences This can either show up as a variable in the demand function or it can change the function altogether.

36

How Income Affects Demand

Remember that an increase in income shifts the

budget curve out, while a decrease in income shifts the budget curve in. Does an increase in income imply that you will always increase demand for a good?
No. It depends on whether the good is a inferior or

normal good.

37

Inferior and Normal Goods Revisited

A good can be classified as a normal good if the

consumption for it has a positive correlation with income.

I.e., when income increases, you consume more of the

good and when income decreases you consume less.

38

Inferior and Normal Goods Revisited Cont.

A good can be classified as an inferior good if the

consumption for it has a negative correlation with income.

I.e., when income increases, you consume less of the

good and when income decreases you consume more.

39

Inferior and Normal Goods Revisited Cont.

A good can be both a normal good and an inferior good.
It all depends on where you are on the level of

consumption of the good and your income.

Suppose you have $10 to use for buying food each week. You might try living off spaghetti because you cannot afford steak. What happens when your income doubles, you might find yourself eating more spaghetti and still no steak. What happens if you have $100 to spend, you might begin to eat less spaghetti and start consuming steak.

40

Engels Curve
Engels curve tells you what happens to your

consumption of a good as you change your level of income.

41

How Price Changes of Other Goods Change Demand

The demand curve for a particular good may shift if

the price of another good changes. How the demand curve shifts will depend on whether the goods are substitutes, complements, or have no correlation.

42

Substitute Good
Good j is said to be a substitute of good i if an increase

in the price of good j causes you to consume more of good i. Good j is also said to be a substitute of good i if a decrease in the price of good j causes you to consume less of good i.
I.e., the demand for product i is positively correlated

with the price of product j.

43

Complementary Good
Good j is said to be a complement of good i if an increase in the price of good j causes you to consume less of good i.
Good j is also said to be a complement of good i if a decrease in the price of good j causes you to consume more of good i.
I.e., the demand for product i is negatively correlated

with the price of product j.

44

Other Items that Affect the Demand Curve

Composition of the Population
Attitudes toward Nutrition and Health Food Safety Lifestyles Technological Forces Advertising

45

Consumer Surplus
Consumer surplus is a measure of the difference between the amount of money a person was willing to pay to buy a quantity of good and the actual price they paid.
This measure is used as a tool in policy analysis. Consumer surplus is represented graphically as the area underneath the demand curve above the price paid for the goods.

46

Graphical Representation of Consumer Surplus

P Consumer Surplus

p=5

q=5

Q
47