Consumer Demand Theory Flashcards
What 3 main tools does consumer demand theory have?
income and prices (budget constraint)
tastes and utility (indifference curves)
behavioural assumption (rationality)
What is the Budget Constraint line?
all possible bundles / combinations the consumer can afford with their money income
Why is the BC line downward sloping?
because it represents the trade off the consumer has to make between consuming 2 goods given their finite income
Where are points on the BC line unattainable and why?
any point above the BC line because it is unaffordable with their income
Where are points on the BC line attainable and why?
any point below the BC Line bc they can afford it BUT consumer not exhausting their entire income (saving a proportion of it)
What does an increase in consumer’s income cause to the BC line?
causes an outward parallel shift
\ –> \
What does an increase in income mean?
that the consumer can consume more of both goods but the trade off between the 2 goods remains the same
What 2 things change to the BC Line if the price of one of the goods becomes cheaper?
1) relative prices (the slope of the BC line)
2)real incomes (BC shifts outwards)`
what happens to the BC line if the price of meals decrease (good on x axis)?
the slope of the BC line becomes flatter
the increase in real income has caused an outward shift (this is represented by swivel + outward shift on graph)
Where does the swivel come from?
the reduction in meal prices relative to cinema tickets
(reduction in x axis good relative to y axis good)
Where does the outward shift movement come from?
the increase in the consumer’s real income
What does the BC tell us?
what the consumer can and can’t afford
doesn’t tell us much with out further assumption eg rationality assumption
What does the rationality assumption dictate?
a consumer will always behave in a utility maximising way
–> consumers always prefer more of a good than less
–> consumer has to be ON the BC line, not above or below
Why does the rationality assumption rule out points below the BC line?
it tells us that consumers prefer more of a good than less
all bundles on the BC line dominate bundles below because all bundles that lie on BC line represent higher quantities of both goods
Why are bundles above BC line ruled out?
bc these are unattainable as the consumer can not afford this
What happens if the price of cinema tickets (y axis good) increase?
causes a swivel and inward shift of the BC line along the X axis intercept
the BC changes to a new one
consumer chooses a point on the new line, this point depends on their preferences
What is utility?
the satisfaction that a consumer derives from consuming a particular consumption bundle
What is the Consumer optimisation problem?
the consumer has infinite wants but finite resources so how do they allocate their expenditure to maximise their wellbeing?
how do you examine the consumer optimisation problem?
construct a simple model of consumer choice
the model is simple - has 2 goods and the consumer is assumed to not save or borrow any money for the sake of simplicity
How would you draw an indifference curve?
just draw a tangent to the consumer BC line
What does the point of tangency between the BC line and indifference curve represent?
the optimal consumption bundle
What is the optimal consumption bundle?
where the indifference curve is just tangent to consumer BC line
What does the non-satiation assumption about tastes allow us to say?
1) consumer will choose a point on the Budget Constraint
2) certain points on the graph will be preferred to others
What bundle should the consumer choose?
the bundle of goods on the BC line on the highest possible indifference curve
this is the point where the indifference curve is tangent to BC
What consumption bundle does the consumer choose?
where the MRS (MARGINAL RATE OF SUBSTITUTION) is equal to relative prices
What is the impact of a change in income for normal goods?
this is NORMAL:
consumption increases when income increases
consumption falls when income falls
eg nike shoes or organic pasta
What is the impact of a change in income for inferior goods?
inferior = small
so consumption falls when income increases
consumption increases when income falls
eg cheap groceries
How does an increase in income affect the BC line when both of the goods are normal goods?
increase in consumer’s income shifts their BC outputs parallel
outward shift
the consumption of both goods rises with income increase, both goods are normal so have + income elasticity of demand
How does an increase in income affect the BC line when one of the goods is inferior and one is normal?
causes a parallel outward shift of BC line
consumption for normal good increases but consumption for inferior good decreases
at higher levels of income, people want to diversify their purchases so but more of the normal good
if normal good is on y axis then tangency point is higher up (closer to y)
What are the 2 consequences of a change in price?
1) Income Effect
2) Substitution Effect
What is the income effect?
holds prices constant
consumers can afford more so wants to consume more of everything (if both goods are normal)
What is the substitution effect?
holds real income constant
its now cheaper for the consumer to get 1 good than another so move consumption from the more expensive good to the cheaper one
What happens to the BC line if price decreases?
BC becomes steeper
What do you have to do to decompose the move from A to C into an income and substitution effect?
place a hypothetical BC line in diagram so that it is a tangent to the consumer’s old indifference curve AND parallel to the new BC line
what is the move from A to B?
(first move)
the pure substitution effect
due only to the change in relative prices of the 2 goods
sub effect happens first bc you need to put subs into the game first
What is the move from B to C?
(second move)
the pure income effect
move to new optimal bundle
due only to the change in real income of the consumer
What is the pure income effect?
(in terms of movement)
the move to the new optimal bundle
How do we get to the substitution effect move?
note the point of tangency between the hypothetical dashed line and the consumer’s old indifference curve
What does the increase in the price of the x axis good cause to BC line?
pushes consumer’s BC line inwards and makes it steeper
how do you derive the market demand curve from the individual consumer’s demand curve?
the market demand curve is simply the horizontal sum of the individual demand curves
how do you work out the market demand?
the sum of units demanded by both consumers at the price
add the 2 demand curves of consumer 1 and consumer 2
what do the income and substitution provide important insights into?
the factors that determine the elasticities of demand curves
Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
what is the trade off in this scenario?
work-leisure trade off
the trade off is between hours of leisure and foregone consumption bc the individual could have worked, earned income + bought goods instead of consuming leisure
What sort of good is leisure?
a normal good so it has positive income elasticity of demand
Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
what happens graphically?
increase in wage rate moves consumer’s BC line outwards + steeper
optimal consumption bundle point shifts
pure sub effect = first move
pure income effect = second
Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
What is the substitution effect in this situation?
reduces the hours the worker spends on leisure bc the opportunity cost of leisure increased due to increase in wage rate
Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
What is the income effect in this situation?
worker spends more time on leisure bc the wage increase increased the worker’s disposable income, increasing the demand for leisure (as it is a normal good)
Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
Does the income or substitution effect dominate in this situation?
income effect dominates the substitution effect
income effect > sub effect
so overall hours of leisure for worker increase
how do you find the old optimal consumption bundle?
find where the old indifference curve was tangent to the old BC line
how do you find the new optimal consumption bundle?
find where the new indifference curve is tangent to new BC line
