2015, Study Session # 4, Reading # 14

DEMAND AND SUPPLY ANALYSIS: CONSUMER DEMAND

2. CONSUMER THEORY FROM PREFERENCES TO DEMAND FUNCTIONS

Consume choice theory:

It deals with study of analyzing what the consumer would like to
consume & what he/she can consume with limited income
available.

Its a branch of microeconomics.

3. UTILITY THEORY: MODELING PREFERENCES AND TASTES

Assumptions:

All consumers know their own tastes & preferences.

Consumers are not rational.

3.1 Axioms of the Theory of Consumer Choice

Completeness preferences:

Preferences must exist.
E.g. A is preferred to B
B is preferred to A
or consumer is indifferent between A and B.

Transitive preference or Transitivity:

If, A is preferred to B &
B is preferred to C
A is preferred to C

More is better or Non-satiation assumption:

Consumers always prefer more to less even if goods are
free of cost.

In case, like air pollution more is considered worse, & the
good is taken as removal of the bad.

3.2 Representing the Preference of a Consumer: The Utility Function

Utility refers to the amount of satisfaction derived from

consuming a commodity.

Cardinal utility approach:

Units of utility can be assigned values like units of weights
or temperature.

Ordinal utility approach:

Utility is assigned a rank ordering i.e. higher rank assigned
to a good means more goods is preferred, for e.g. U(A) >
U(B)

Limitation:

Does not allow for the calculation and ranking
difference between two bundles.

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2015, Study Session # 4, Reading # 14

Indifference Curves

It shows consumption bundle among which the

individual is indifferent.

Consumption bundle refers to combination of goods
& services that consumer would like to consume.

Higher the indifference curve, greater the utility.

Transitivity assumption: Two

indifference curves for a consumer
never intersect each other.

Completeness assumption: One IC

passes through every point in the
set.

Characteristics

Indifference curve is always convex to origin.

Indifference curve is always downward sloping.
There are always infinite number of curves.
Indifference curves never intersect each other.

Marginal Rate of Substitution
)

Rate at which a consumer is willing to trade or substitute one good for

another

 

substitution 

Changes continuously as we move along the indifference curve.
Different consumer preferences different

Steeper the indifference curve, greater

Gains from voluntary exchange can only be achieved in case of
different


3.4 Indifference Curve Maps

A group or family of ICs is known as indifference curve map.

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2015, Study Session # 4, Reading # 14

4. THE OPPORTUNITY SET: CONSUMPTION, PRODUCTION, AND INVESTMENT CHOICE

4.1 Budget Constraint

Budget (income) constraint line shows all alternative combinations of two goods that
consumer can afford to purchase given his fixed income & price of two goods.

I/PY

PX QX + PYQY

I/PX
 



Slope measures the rate at which the consumer will trade good Y to purchase another unit
of good X.

4.2 The Production Opportunity Set

It shows the greatest quantity of one product that a company

can produce for any given number of the other good that it
chooses to manufacture.

4.3 The Investment Opportunity Set

It shows highest return that investor can earn for a given

amount of risk undertaken.

5. CONSUMER EQUILIBRIUM: MAXIMIZING UTILITY SUBJECT TO THE BUDGET CONSTRAINT

Utility maximization:

Utility is maximized at the point where the highest IC is just
tangent to the budget constraint line i.e. slope of indifference
curve = slope of budget line.


 

5.2 Consumer Response to Changes in Income: Normal and Inferior Goods

Normal goods:
income
consumption of goods.

Inferior goods:
income  consumption of goods.

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2015, Study Session # 4, Reading # 14

5.3 How the Consumer Responds to Changes in Price

Good X
Price

Budget Line

Rise
Fall

Steeper
Flatter
Good Y

Price

Budget Line

Rise
Fall

Flatter
Steeper

6. REVISING THE CONSUMER'S DEMAND FUNCTION

Income effect:

Fall (rise) in price increase (decrease) in real income (purchasing power).

Direction of income effect depends on whether the good is normal or inferior.

Substitution effect:

It refers to change in consumption that occurs due to the change in the relative
price the good (cheaper goods are substituted for expensive goods).

Substitution effect of price is:

Negative for price increase.

Positive for price decrease.

Normal Goods

Income
Qd.


Both effects lead to
Qd.



Both effects lead to Qd.

Inferior Goods

Income Qd.

Income effect and substitution effect move in opposite direction.

P; substitution effect
Qd
income effect Qd.


P; substitution affect Qd
income effect
Qd.

Theoretically, when IE > SE, law of demand may be violated.

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2015, Study Session # 4, Reading # 14

Saving & Interest Rates



Individuals save more.


 
Individuals save less.

6.4 Giffen Goods

P
Qd.
It violates law of demand.
They are inferior goods for which IE>SE.
All giffen goods are inferior goods but; not all inferior goods are
giffen goods.

6.5 Veblen Goods

P
Qd.

E.g expensive shoes, designer dress etc.

They are also known as status- symbol or ostentatious goods
because they represent conspicuous necessities & consumption.

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