The Theory of Demand Lecture 7: The Theory of Demand Readings: Chapter 9.

Lecture 7: The Theory of DemandThe Theory of Demand

Readings: Chapter 9

Lecture 4:

The Theory of Demandhe Theory of Demand

Where does demand come from?

Scarcity encourages rational decision-making

over household consumption choices.

Rational choice leads to purchase decisions

which leads to the social phenomenon of

demand.

We therefore build our theory of demand on a

theory of rational individual choice.

(Methodological Individualism)

What factors influence choice?What factors influence choice?

An individual’s choices are

influenced by: what they can afford,

their preferences.

How are consumption decisions made?How are consumption decisions made?

Search the person’s affordable set to find the

consumption choice that provides the highest

level of satisfaction given her preferences.

Problem:Problem: How does a rational individual search

the family’s affordable set to find the best choice?

Solution:Solution: We need a simple model of

preferences to explore this decision problem.

A simple model of choiceA simple model of choice

Choice can be modeled as the result of an interaction between: 1. Affordable Set (or consumption

possibilities) Family income (M) and prices (P) of

goods and services given defines a family’s affordable set

The budget line is the boundary between affordable and unaffordable consumption choices

2. Preferences — Indifference Map

M P Q P Q P Qn n 1 1 2 2 . . .

M P Q P Q P Qn n 1 1 2 2 . . .

A simple application of the model:A simple application of the model:

As before we will simplify the model by having

only two commodities – pop and movies.

The budget line simplifies dramatically

Example: Suppose that income is $30, the price

of a movie is $6, and the price of a pop is $3.

M P Q P QPop Pop M ovies M ovies

30 3 6 Q QPop M ovies

AffordableSet

Unaffordable

IncomeMoviesPop

$30$6$3

The Affordable SetThe Affordable Set

Textbook p. 169

0

2

8

10Pop

Movies2 4 6 8

4

1 3 5 7 9 10

6

a

b

c

d

e

f

Budget line

Copyright © 1997 Addison-Wesley Publishers Ltd.

Affordable Set and the Budget LineAffordable Set and the Budget Line

Textbook p. 149

0

2

8

10Pop

Movies2 4 6 8

4

1 3 5 7 9 10

6

a

b

c

d

e

f


M PM ovies

QM ovies

PPop

QPop

QP

MPP

PmPP

Qm

Affordable SetAffordable Set

Intercepts measure real income in

movies (x-intercept)

pop (y-intercept)

Pm steeper budget line, fixed pop-intercept

Pp flatter budget line, fixed movie-intercept

M rightward parallel shift budget line

Preferences and Indifference CurvesPreferences and Indifference Curves

Indifference curves

join combinations goods giving equal

satisfaction

generally slope downward and bow towards

origin

farther from origin levels of satisfaction

never intersect

A Preference MapA Preference Map

Textbook p.173

Movies0 2 4 6 8 10

2

4

6

8

10Pop

l0

l1

g

c

I2

j


Preferences and Indifference CurvesPreferences and Indifference Curves

Marginal Rate of Substitution (MRS)

magnitude of slope of indifference curve

diminishing marginal rate of substitution —

MRS as move down along indifference

curve

substitutability between goods straighter indifference curves

substitutability between goods more tightly curved indifference curves

The Marginal Rate of SubstitutionThe Marginal Rate of Substitution

Textbook p. 174

Movies0 2 4 6 8 10

2

4

6

8

10Pop

l1

c

MRS = 2

g

MRS = 12


The Household's Consumption Choice

At the best affordable point: each household spends all its income and

achieves maximum satisfaction. each household’s budget line and

indifference curve have same slope MRS = relative price

Despite the fact that every household chooses a different consumption bundle, every household will have the same MRS as every other household because they face the same prices.

c

Best affordable point

The Best Affordable Point

Textbook p. 176

Movies0 2 4 10

6

10

Pop l1

5

l2l0

i

h


Predicting Consumer Behaviour

Price effect =consumption resulting fromprice of good

To analyze the price effect, consider our example

in which a person with $30 must decide how much

of his money to spend on movies and pop.

Suppose the price of movies falls from $6 to $3,

while the price of pop stayed constant at $3.

This will alter the affordable set (budget line).

continued


To see how it affects the budget line consider

the following two cases.

If all the $30 is spent on movies, a reduction in

the price of movies from $6 to $3 makes it

possible to consume as many as 10 movies.

If however, the individual spends all $30 on pop,

the reduction of the price of movies would not

change his consumption.

Clearly the budget line hinges out.

Price Effect

Textbook p. 178

Movies0

10Pop

10

l2

l1

2

6 c

Movies $6

5

5j

Movies $3


2

6 a2

6 c

5

3 b

5

5j

Price Effect and Demand Curve

Textbook p. 1780

P

10Movies

0

10Pop

10

l2

l1Movies


Individual and Market Demand

The last table shows how individual demand is

related to individual choice given preferences

and an affordable set.

Q: Where does market demand come from?

A: Market Demand Market demand curve is simply the

sum of individual demand. Graphically this is the horizontal sum

of individual demand curves

Individual and Market Demand Curves:Lisa’s Demand

0

2

2 4 6

4

5

6

Q

P

3

Textbook p. 158Copyright © 1997 Addison-Wesley Publishers Ltd.

Lisa’s demand

Individual and Market Demand Curves: Chuck’s Demand

0

2

2 4 6

4

6

P

3

Textbook p. 158

Q


Chuck’s demand

Individual and Market Demand Curves: Market Demand

0

2

2 4 6 8

4

7

6

Q

P

3

Textbook p. 158Copyright © 1997 Addison-Wesley Publishers Ltd.

Market demand

Individual and Market Demand Curves

0

P

3

5 Q0

P

3

Q

Lisa’s demand Market demand

Textbook p. 158

(a)

0

P

3

2 7Q

Chuck’s demand

(b) (c)



Q: What determines the elasticity of demand?

A: The size of the price effect.

Q: What determines the size of the price effect?

A: Price effect = substitution effect + income effect

continued


Substitution effect —

price consumption

Income effect —

for normal goods,

(hypothetical) income consumption

for inferior goods,

(hypothetical) income consumption

Income Effect

Textbook p. 179

Movies0

Pop

l2

l1

10

105

5j Income

$30

7

7

4

k3

Income$21


Income Effect and Change in Demand

Textbook p. 179

0

l2

l1

© 1997 Addison-Wesley Publishers Ltd.0 7 10

6

10

105

5j

5

b

D0

3

7

7

4

k3

4

c

D1

P

Movies

Pop

Movies

Price Effect

Textbook p. 180

Movies0

Pop

4

l2

l1

10

2 5

6 c

Income $30Movies $6

10

5j

Income $30Movies $3

7

7


Substitution Effect

Textbook p. 180

Movies0

Pop

10

5

l2

l1

10

2 5

6 c

Income $30Movies $6

4

3k

7

Income $21Movies $3

7


Income Effect

Textbook p. 180

Movies0

Pop

l2

l1

4

3Income $21Movies $3

7

7

k

j

10

5 10

5

Income $30Movies $3


j

Income $30, Movies $3

Price Effect = Substitution Effect + Income Effect

Textbook p. 180

Movies0

Pop

10

l2

l1

10

2 5

6 c

Income $30, Movies $6

4

3k

7

7


5


For normal goods

substitution and income effects work in

same direction

Example: Pmovies both consumption and

income effect push Qmovies

Implication: Normal goods tend to be price

elastic in demand.


For inferior goods

substitution and income effects work in

opposite directions

Example: Pbus substitution effect causes

Qbusbut income effect causes Qbus

Implication: Inferior goods tend to be price

inelastic in demand.

Value and Demand Theory

Demand Theory can do more than explain

demand. It sheds light on questions about value.

Q: What do market values have to do with human

values? Many believe that market values are

often at odds with human values?

A: Economists used to believe there was no

connection between the exchange value (market

price) and the use value (intrinsic value) of

commodities.


The reason for this belief in a disconnection

between market value and use value is found in

The Water Diamond Paradox:

Water has enormous use value but has a

low price, while a diamond has little use

value yet has a high price.

This seems to suggest that there is no

connection between market price and use value.


Q: Is there no connection between market value

(price) and use value?

A: No! There is an important connection.

Water is plentiful. Even though the total

utility from water is high, the marginal utility

is low. Diamonds are scarce and while the

total utility is low, the marginal utility is high.

Marginal analysis shows us the link between

market price and use value.


Q: What is the benefit from participating in

markets if you are a buyer?

People will only participate if the price is lower

than the value they place on the good.

This creates a consumer surplus that the buyer

realizes from her purchase.

Market price

Maximum priceswilling to pay for1, 2, 3, and 4 movies

Consumersurplus

Consumer Surplus: Individual

Textbook p. 161

0 2 4 6 81 3 5 7

7

5

3

1

8

6

4

2

P

Q

D


Marketprice

Consumersurplus

Consumer Surplus: Market

Textbook p. 161

0 2 4 6 81 3 5 7

7

5

3

1

8

6

4

2

P

Q

D


The model of consumer choice can be used to study the allocation of time between work and leisure.

The two “goods” are leisure and income—where income represents all other goods.

Lisa buys leisure by not supplying labour and by forgoing income.

So the “price” of leisure is the wage rate forgone.

Work-Leisure Choices

The labour Supply Curve By changing the wage

rate, we can find a person’s labour supply curve.

An increase in the wage rate makes leisure relatively more expensive (higher opportunity cost to not working) and

has a substitution effect towards less leisure (towards more work).



A higher wage also has a positive income effect on leisure.

If the income effect is weaker than the substitution effect, the quantity of work hours increases as the wage rate rises.

When the wage rate rises from $5 to $10 an hour, work increases from 20 to 35 hours a week—the move from A to B.

But if the income effect is

stronger than the

substitution effect, the

quantity of work hours

decreases as the wage

rate rises.

When the wage rate rises

from $10 to $15 an hour,

work decreases from 35 to

30 hours a week —the

move from B to C.


The move from A to B

when the wage rate

increases from $5 to $10

an hour means that the

labour supply curve

slopes upward over this

range.


The move from B to C

when the wage rate

increases from $10 to $15

an hour means that the

labour supply curve bends

backwards above a certain

wage rate.


Historical evidence shows

that the average workweek

has fallen steadily as the

wage rate has increased.

With higher wage rates,

people have decided to use

their higher incomes in part

to “buy” more leisure.


End of Lecture 7

The Theory of Demand Lecture 7: The Theory of Demand Readings: Chapter 9.

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Transcript of The Theory of Demand Lecture 7: The Theory of Demand Readings: Chapter 9.