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Yale ECON 115 - Individual and Market Demand

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Individual and Market Demand1. Optimal Choice and Demand2. Change in the Price of a Good(a) Income Effect(b) Substitution Effect3. Adding Up: From Individual to Market Demand Curves4. Consumer Surplus5. Network Externalities1Optimal Choice and Demand• Recall we have been working the example in which there are just twogood: food and clothing.• Figure 4.1• Suppose the consumer’s weekly income is $20 and the price of food is$1 and the price of clothing is $2.• Maximizing point is B.• Suppose the price of food increase to $1.• Suppose the price of food decreases to $0.50.• The price-consumption curve or price-expansion path is the set ofutility maximizing bundles as the price of one good varies (holdingconstant income and the prices of all other goods).2• We can use the price-consumption path to trace out the demand curve.• The demand curve is sometime called the “willingness to pay curve”– Recall the marginal rate of substitution measures the maximum ofone good the consumer is willing to pay in order to obtain one unitof the other good.– As the price of food falls, the price ratio and the MRS fall as well.Because the consumer is maximizing utility, the MRS of food forclothing decreases as we move down the demand curve.– That is, the more food a consumer buys, the units of clothing he orshe is willing to give up in order to buy an additional unit falls.• Also note that utility of the consumer is increasing as we move down(to the southeast) the demand curve.3Income Changes• Figure 4.2• An increase in income results in an outward parallel shift of the budgetconstraint.• The income-consumption curve is the set of utility maximizing bun-dles as income varies (and prices are held constant).• Changing income shifts the entire demand schedule (curve).4The Consumption Possibilities of American Workers, 1895-200• Over the past century, the budget line of the typical American workerhas shifted radically outward as the nation as become vastly richer.• J. Bradford DeLong’s paper athttp://econ161.berkeley.edu/TCEH/Slouch wealth2.html• DeLong compared the cost of a number of items in the 1895 Mont-gomery Ward catalog to the cost of similar items today by calculatingthe number of hours an average worker would need to work to earnenough money to buy them.• If we assume that the worker puts in 2,000 hours per year – 40 hoursfor 50 weeks – we can calculate how many units of each good a workercould purchase by spending an entire year’s income only on that good.5• Here’s what he found– In 1895, an average worker’s annual income would have bought 7.7one-speed bicycles; in 2000, it would have bought 278 bicycles.– In 1895, the worker’s income would have bought 45 full sets of dinnerplates; 2000, it would have bought 556 sets.– In 1895, a worker’s income would have bought 0.83 of a Steinwaypiano; in 2000 it would have bought 1.8 pianos.• On average incomes have grown 7-fold• Underestimates growth since lots of items, (e.g. computers, cell phones)were not available at any price in 1895.• ADVERTISEMENT: On March 23, we will have a guest speaker.– Professor Benjamin Friedman of Harvard University, will discuss hisnew book The Moral Consequences of Economic Growth.6Engle Curves• Another way of showing how a consumer’s choice of a particular goodvaries with income is to draw an Engle curve – a graph relating theamount of the good consumed to the level of income.• A normal good is a good that a consumer purchases more of as incomerises holding prices constant.– That is, the income elasticity of demand is positive.– Examples: Broadway tickets, really most goods• An inferior good a good that a consumer purchases less of as incomerises holding prices constant.– That is, the income elasticity of demand is negative.– Examples: taking the bus, Ramin noodles7Where Have All the Farmer’s Gone?• In 1940 about 17 percent of the country lived on farms. Today it is lessthan 1 percent.• Food as a income elasticity of demand of much less than 1.– As consumers grow richer, other things equal, spending on food risesless than income.– Share of incomes spent on food will decrease.• Technological progress has led to shifts out in the supply curve for food.– This leads to a decrease in the price of food.– Demand for food is price-inelastic so total revenue for farmers hasgone down.– Consumers have gained from farming’s technological progress, notfarmers.• Farming is a victim of success.8Change in the Price of a Good: Income and Substitution Effects• Earlier in this lecture, we analyzed the overall effect of a change in theprice of a good.• We want to decompose the overall effect of a change in the price of agood into two effects: income and substitution.The Substitution Effect• When the price of a good falls, the good becomes cheaper relative toother goods. Conversely, a rise in the price makes the good more ex-pensive relative to other goods.• In either case, the consumer experiences a substitution effect.• The substitution effect is the change in the amount of a good thatwould be consumed as the price of the good changes, holding constantall other prices and the level of utility.– For example, if the price of food rises, the consumer may substituteother goods for food to achieve the same level of utility.9The Income Effect• When the price of a good falls, the consumer’s purchasing power in-creases, since she can now buy the same bundle of goods as before theprice decrease and still have money left over to buy more goods. Con-versely a price increase lowers the consumer’s purchasing power sinceshe can no longer afford to buy the same bundle.• The income effect is the change in the amount of the good that aconsumer would buy as her purchasing power changes, holding pricesconstant.10The Substitution Effect in 3 Easy StepsWe are looking at Figure 4.61. Find the initial bundle (the bundle the consumer chooses at the initialprice). Point A.2. Find the final bundle (the bundle the consumer chooses after the pricefalls). Point B.3. Find an intermediate decomposition bundle that will enable us to iden-tify the portion of the changing quantity due to the substitution effect.We can find this basket by keeping two things in mind.(a) The decomposition bundle reflects the price change so it must lie onthe on budget line that is parallel to new budget line.(b) The decomposition basket reflects the


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