320 33 Powerpoint Slides Chapter 3 Household As Consumer Behind Demand Curve

Chapter 3
Household as a consumer- Behind

the demand curve
Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
The decision making process of
the consumer
Preference set Constraints
Optimal decision

Assumptions
• Completeness
• Transitivity
• Non satiation

Utility and Optimization
• Utility:
- reflects a rank ordering of preferences.
- is a magnitude indicating the direction of
preferences
• Optimization:
- Cardinal Approach and Ordinal Approach

Optimization
The Cardinal Approach
• Utility is cardinally measurable and the
objective is to maximize utility
• The Law of Diminishing Marginal Utility
• Optimization Rule 1:
When only one good is consumed and is
available for free, consume till
MUx = 0
Optimization
• Optimization Rule 2:
When only one good is consumed and is
available for a price:
Consume till MUx = Pricex
• Optimization Rule 3:When more than one
good is consumed and the goods’ prices are
different:
Consume till MUx/Px = MUy/Py = MUz/Pz

Optimization- The Ordinal approach
• Rank ordering of preferences

• Combinations of goods
Two inputs required to arrive at optimal

combination:
1. Preference set
2. Opportunity set

Preference Set- Indifference
Curves
• Indifference Curve:
Combination of goods that yield the same level
of satisfaction.
• Properties of Indifference curves:
- Slope downward
- Convex to the origin
- Non intersecting

Shapes of Indifference curves
MRS decreasing MRS Constant=1 One fixed proportion

Normal substitutes perfect substitutes Complements

Opportunity Set
• Defined by Budget Constraint.

6x + 3y = 60
Given Px = 6 and Py = 3
Graphically,
Y
20 -Px/Py is the Slope
10 X
Consumer’s Equilibrium- The
Optimal Combination
y
e
x
At ‘e’ slope of the budget line is equal to the slope
of the Indifference curve.

Consumer’s Equilibrium
• Slope of the budget line: - Px/Py
• Slope of Indifference curve: MUx/MUy
• Equilibrium : MUx/MUy = Px/Py

or MUx/Px = MUy/Py

Changes in equilibrium when prices
change
• Relative price changes get reflected in changes in
slope of the budget line.
• New point of tangency between the indifference

curve and the new budget line

Changes in equilibrium
• Joining all these points of tangency gives the

Price Consumption Curve. (PCC)
Y
PCC
Price of X is falling.
X
Derivation of the demand curve
• Data contained in the PCC:

- Optimal level of consumption of X
- Optimal level of consumption of Y
- Prices of X and Y
• Demand curve for X requires –
- Price of X.
- Quantity consumed of X.

Demand Curve
• Every point on the PCC gives the price of X and

quantity demanded/consumed of X
Thus,
Px
Qx
Changes in equilibrium when
income changes
• Income changes show up as parallel shifts of the
budget line
• New points of tangency between indifference

curves and the new budget lines

Changes in equilibrium
• Joining all these points of tangency gives

the Income Consumption Curve (ICC)
ICC
X
Slope of the ICC
• If the goods are ‘Superior’, the ICC is

upward sloping
• If one of the goods is ‘Inferior’, the ICC

is downward sloping

Slope of the PCC
• If the goods are normal, PCC is upward

sloping
• If PCC is downward sloping, then one of them

is a Giffen Good

Giffen good
Income effect
• Price effect +
Substitution effect
• Substitution effect is inversely related to price.
• Income effect can be inversely related to
changes in income – Inferior Good
• Income effect can be positively related to
income-Superior good

Giffen Good
• If income effect is inverse and large enough to

offset the substitution effect, then it is a Giffen
Good
• The Demand curve for Giffen Good will have a

positive slope

Applications of Indifference curves
• Welfare effects of a Direct tax Vs Indirect

tax:
- Indirect tax changes slope of Budget line.
- Consumer shifts to a lower indiff curve.
- Direct tax (income tax) shifts the budget
line parallel inwards.
-Consumer shifts to lower indiff curve but..
Applications
• .. Higher than in the Indirect tax case
Why??
Indirect tax changes price structure.

So, imposes both substitution and income
effect

Applications
• Whereas direct tax imposes only income

effect.

Applications
• Another application: Work –leisure choice
• Two goods- Leisure and other goods
• Boils down to – Leisure and work

Applications
• Budget line: c = w(T- n)
T is max no: of work hours
n is no: of leisure hours
• Opportunity cost of leisure is ‘w’(wages)
• Therefore, c = wT – wn
• Slope of the Budget line is ‘w’.

Applications
• If w increases , leisure becomes costlier.
• If w decreases, leisure becomes cheaper.
• Substitution effect of a change in ‘w’ :
if ‘w’ increases, leisure becomes costly and
hence less leisure and more work.
• Income effect of a change in ‘w’:
if ‘w’ increases, preference for leisure increases
(since leisure is a superior good)

Applications
• If substitution effect is > income effect,
then,
‘w’ increase will lead to more work
• If income effect is > substitution effect,
then,
‘w’ increase will lead to more leisure.

Applications
• At higher levels of ‘w’, income effect
becomes > substitution effect.
So we have a backward bending Supply
curve such as: w
QL


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Chapter 3

Household as a consumer- Behind

Managerial Economics, 2e All rights reserved

Preference set Constraints

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

• Rank ordering of preferences

Two inputs required to arrive at optimal

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

MRS decreasing MRS Constant=1 One fixed proportion

Managerial Economics, 2e All rights reserved

• Defined by Budget Constraint.

Managerial Economics, 2e All rights reserved

• Slope of the budget line: - Px/Py

• Slope of Indifference curve: MUx/MUy

• Equilibrium : MUx/MUy = Px/Py

Managerial Economics, 2e All rights reserved

• New point of tangency between the indifference

Managerial Economics, 2e All rights reserved

• Joining all these points of tangency gives the

• Data contained in the PCC:

Managerial Economics, 2e All rights reserved

• Every point on the PCC gives the price of X and

• New points of tangency between indifference

Managerial Economics, 2e All rights reserved

• Joining all these points of tangency gives

• If the goods are ‘Superior’, the ICC is

• If one of the goods is ‘Inferior’, the ICC

Managerial Economics, 2e All rights reserved

• If the goods are normal, PCC is upward

• If PCC is downward sloping, then one of them

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

• If income effect is inverse and large enough to

• The Demand curve for Giffen Good will have a

Managerial Economics, 2e All rights reserved

• Welfare effects of a Direct tax Vs Indirect

Indirect tax changes price structure.

Managerial Economics, 2e All rights reserved

• Whereas direct tax imposes only income

Managerial Economics, 2e All rights reserved

• Two goods- Leisure and other goods

• Boils down to – Leisure and work

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

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