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Principles of Economics Class 2 Demand and consumer behavior.

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Principles of Economics Class 2 Demand and consumer behavior
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Principles of Economics

Class 2Demand and consumer behavior

Utility

• Utility (u or TU)is a pleasure that consumer gains when he consumes goods and services.

• Marginal utility MU is an increase in utility when quantity of consumed products increases by one unit.

• Law of diminishing MU states that MU becomes diminishes when the amount of consumed goods increases.

• Observation of marginal values was started in 1870’s bz Jevons, Menger and Walras.

Total utility and marginal utility

Indifference curves map

•Indifference curve is a curve that connects all the baskets (combinations) of goods that give the same value of pleasure to a consumer.•Its slope is Marginal rate of substitution MRS which tells what is the amount of good Y a consumer is willing to give up in order to get additional unit of X staying on the same level of utility.

u2

qy

0 qx

u3

u4

u1

Δqx = 1

Δqy = MRSxy

Indifference curves map

Budget

• Consumer can buy only those combinations of goods that satisfy the following rule:

(where p = price and q = quantity)• The slope of a budget line equal to ratio of

prices• The area below and on the budget line is

affordable with the income I.

Iqpn

iii

1

qy

0 qx

Iqpqp yyxx

xy

x

yy q

p

p

p

Iq

y

x

p

p

yp

I

xp

I

Consumer equilibrium

• The equilibrium is obtained when budget line is tangent to indifference curve.

• In that case there is no other consumer basket on the budget line that can yield higher utility.

y

xxy p

pMRS

y

xxy MU

MUMRS

y

y

x

x

y

x

y

x

p

MU

p

MU

p

p

MU

MU

u2

qy

0 qx

u3

u1

xy

x

yy q

p

p

p

Iq

y

xxy p

pMRS

Affordable area

Changes in the equilibriumqy

0u1

qx

u2

Price of X falls

Price-consumption curve

qy

0u1

qx

u2

Income increases

Income-consumption curve

Income and substitution effect

• INCOME EFFECT is the change in the consumer’s equilibrium due to a change in the purchasing power.

• SUBSTITUTION EFFECT is the change in the consumer’s equilibrium due to a change in relative prices while retaining the same utilitz level.

u2

qy

0 qx

u1

xy

x

yy q

p

p

p

Iq

y

xxy p

pMRS

Substitution effect

Income effect

qy

0u1

qx

qx

Deduction of an individual demand

u2

px

0

d

The smaller the price of X, the greater its demanded quantity

Px falls

Deduction of the market demand

dM

p

0 q

Market demand is a horizontal summation of individual demands (competitive good)

Causes of demand shifts

d

p

0 q

•Price of complement rises,•Price of substitute falls•Income falls (normal good),•Income rises (inferior good)•Good becomes less useful or more substitutable

•Price of complement falls,•Price of substitute rises•Income rises (normal good),•Income falls (inferior good)•Good becomes more useful or less substitutable

d

p

0 q

s

EConsumer’s surplus

Producer’s surplus

Consumer surplus is the difference between the price consumer pays and the price he was willing to pay.

Producer surplus is the difference between the price the seller charges and the price at which he was willing to sell.

Consumer’s and producer’s surplus

Exercise 1• Consumer buys 3 goods, A, B and C. The pleasure of consumption of these

goods increases as THE consumer increases the quantity:

Q = 1 2 3 4 5 6 7 8 9 10

A 95 165 210 240 258 275 280 285 289 293

B 400 700 900 1000 1020 1030 1038 1044 1048 1050

C 70 130 180 225 265 300 328 348 360 366

A) Calculate marginal utilities for each goodB) If the consumer has 52$ and prices of goods A, B and C are 1$, 2$ and 4$

respectively find the optimal consumption basket when consumer spends the entire income.

C) What if income falls down to 36$?D) Draw TU and MU for good B

Exercise 2• 1)Let a consumer have the income of 150$ which can be spent on shirts and

pullovers. Price of a shirt is 5$ and price of a pullover is 24$. He spends the entire income.

• a)When consumers maximizes his utility?

• MUx/Px=MUy/Py

quantity TU for shirts TU for pullovers

1 60 4002 115 7503 165 10504 210 13005 250 15006 285 16507 315 1750

• 3 combinations=> 1) 3(s) and 4(P) -> 3*5$ + 4*25$ = 115$ 2) 5(s) and 5(P) -> 5*5$ + 5*25$ = 150$ 3) 7(s) and 6(P) -> 7*5$ + 6*25$ = 185$

• Consumer maximizes his utilitz when he buys 5 shirts and 5 pullovers• Total utility (TU) =TU(p)+TU(s)=250+1500 = 1750

• b)Pri kojoj kombinaciji košulja i pulovera potrošač maksimizira svoju korisnost ako se dohodak smanji na 115$ i kolika je ukupna korisnost?

• Potrošač max. svoju korisnost pri kombinaciji od 4 pulovera i 3 košulja!

• Ukupna korisnost(TU) =TU(p)+TU(k)=1300+165 = 1465

• c)Is it possible to acquire the same level of utility if price of shirt 10$ and price of pullover 50$ having the income of 280$?

• TU =1750 for A) 5 pullovers and 5 shirts (5*10$+5*50$) = 300$ B) 7 pullovers and 0 shirts (7*50$+0*10$) = 350$

• It is no longer possible to maintain the previous level of utilitz with the given prices and income.

• Note: by how much changed prices and the income? It can give you an immediate answer to c)!

• Exercise 3• James is ready to pay 10 kn for the first bottle of coke, for the second 8 kn,

3rd 6 kn and 4th 4kn. Find his consumer surplus if the current price of a bottle of coke is 4 kn.

• TABLICA

• CS =6+4+2+0 = 12! b)If the price went up to 6 kn what is the amount of consumer’s surplus?

• 4+2+0 = 6 !

Bottles of coke

willing to pay market priceconsumer

surplus

1 10 4 62 8 4 43 6 4 24 4 4 0

Exercise 4

• Demand and supply equations are qd = 10 – 2p and qs = 0.5p. Find CS, PS and the equilibrium price and quantity.

• 10 – 2p = 0.5p => p*= 4, q*= 2.• CS = (5 – 4)*2/2 = 1• PS = (4 – 0)*2/2 = 4• TS = 5


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