Chapter Two: The Consumer Theory PDF

MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 5 Chapter Two: The Consumer Theory consumers make rational choices as they act in their own self-interest. Thus, there are two effects that follow f...

MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 5 Chapter Two: The Consumer Theory consumers make rational choices as they act in their own self-interest. Thus, there are two effects that follow from their attempts to maximize their well-being when the price of a commodity changes. o These effects, together, ensure a downward sloping demand curve. o The income and substitution effects combine to cause the demand curve to slope downwards. o It is the combination of the income and substitution effects, and their relative strength, that causes an individual and hence a market demand curve to slope downward. 1) The income effect. 2) The substitution effect. The income effect is the fact that as a person's The substitution effect is the fact that as the price of a income increases or the price of good goes commodity increases, consumers will buy less of it and more down, which effectively increases demand over of other commodities. goods more of everything will be demanded.  In other words, the consumer will attempt to substitute  The income effect suggests that as income other goods for the commodity that becomes more goes down or price increases then less of expensive. The substitution effect simply reinforces the the commodity will be purchased. idea of a downward sloping demand curve. The income effect arises from a reduction in the price of a commodity, having the effect of a consumer having to spend less on that commodity, hence the same as having more income. o Conversely, as price increases, the consumer will purchase less of that commodity and buy more of a substitute; this is the substitution effect. However, there is an interesting exception to this general rule called “Giffin's Paradox”. Giffin's goods or Giffin's Paradox is a rare economic phenomenon in which some commodities may have an upward sloping demand curve. Such commodities are called inferior products or inferior goods. The term inferior is Not necessarily due to the low-quality problems with these goods, but because the analysis is “inferior” and not generalizable to all commodities. This occurs because of the income effect resulting in a smaller demand for a commodity. o In other words, the income effect overcomes the substitution effect. There are at least two types of goods that often exhibit an upward sloping demand curve. o One is a necessity good for very poor people and o the other is one for which a high price creates a snob effect. As shown in figure (1), it is clearly seen that as price decreases from P1 to P2 the quantity demanded decreases from Q1 to Q2, o a snob appeal may go down from the loss of a prestigiously high price. That is, consumers who value the product (simply because it is high priced) leave the market as the price falls. As price increases from P2 to P1 o If the car is extremely expensive, i.e., Rolls Royce, the snob effect may be the primary motivation for the purchase. Every so often, people will drive expensive cars, simply because of the image it creates. o In the case of poor people who experienced the price of necessity increasing, their limited income may result in their buying more of the commodity when its price increases. o poor people can’t afford other more luxurious goods, therefore they have to buy more of the very commodity whose price wrecked their budgets. o For example, if the price of rice increases in a less developed country, people may buy more of it because of the pressure placed on their budget prevents them from buying beans or fish to eat with their rice.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 6 Consumer Equilibrium The rational behavior assumption states that the economic agents acting in their self-interest.  This idea of rational behavior allows the demanding examination of economic activity. Without rationality, our analyses fail to obey the basic underlying assumption upon which most of economics is built.  While acting in their own self-interest, consumers attempt to maximize their benefits or utility, given their own available income or resources devoted by them to buy those goods and services. The utility maximizing rule means that consumers will balance the utility they receive from the consumption of each good or service against the cost of each good or service they buy, to know the amount of each good or service that maximizes their total utility. This maximization level of consumption will be obtained only when: Where: MU1 the marginal utility of good one 𝑃1 the price of good one MU2 the marginal utility of good two 𝑃2 the price of good two MU i the marginal utility of good 𝑖 𝑃𝑖 the price of good 𝑖 𝑀U𝑚: the marginal utility of the monetary unit, i.e. one Egyptian pound or one US dollar …... etc. That is, when the consumer approaches his equilibrium each of the ratios of marginal utility to price will be equal in all goods or services he purchases. If any single ratio such as from good one is greater than the others, the marginal utility received from the consumption of good one is greater than marginal utility of the monetary unit, and this means the consumer has not purchased enough of that good.  Therefore, the consumer must buy more of good one causing marginal utility to go down to the point at which all ratios are equal. Conversely, if the ratio from good two, for example, is less than other ratios, then the consumer has bought too much of good two, i.e. the marginal utility of the monetary unit is larger than the marginal utility received from good two and needs to cut back. Whether intentionally or not, rationality entails that each individual consumer allocates their income in such a manner as to meet the restrictions of the above equation that is when the consumer is said to be in equilibrium.  A consumer is always seeking those levels, but because of changing prices and changing preferences, it is understood that the consumer is always seeking, but never quite at equilibrium. what does utility mean? One can define utility as a measurement of happiness or satisfaction derived from consuming a good or a service.  However, we must keep in our mind that utility and usefulness are not synonymous.  Utility is subjective measurement therefore it is difficult to quantify (but still units of utility are named “utils”. Total and Marginal Utility Total Utility is equivalent to the total amount of satisfaction or pleasure an individual receives from consuming some specific quantity of a good or service. Marginal Utility is the extra amount of satisfaction an individual gets from an additional unit of a good or service.  In other words, it is the change in total utility due to the consumption of one more unit of a good or service.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 7 The law of diminishing marginal utility Consuming a good or a service gives the consumer different levels of satisfaction.  For example, when someone is very hungry the satisfaction, he gets from the first bite of a burger sandwich will be of high value or utility for him if compared to utility he gets from the second bite which has utility higher than the third bite…. and so on. When he finishes his burger meal, he accumulated utility until he became full or satiated, this is total utility, whereas the utility he gets from every single bite or unit is the marginal utility which declines or diminishes with every unit consumed. Total utility increases up to a certain point which is known as “saturation point” which reflects the maximum satisfaction the consumer gets from consuming some units of a good or a service, but the marginal utility is diminishing. It is clearly seen from table (1) that total utility increases up to 26 utils when the consumer gets the fourth cookie reflecting his saturation point after which total utility goes down. On the other hand, marginal utility of the first cookie is the highest after which marginal utility goes down with every additional cookie consumed and approaches zero at the saturation point and then turns to be negative forming the law of “diminishing marginal utility”. The numbers of total and marginal utility shown in table (1) can be depicted graphically as represented in figure (2). Figure (2) Total& Marginal Utility of Cookies (The law of diminishing marginal utility) The total utility curve slopes upward at decreasing rates until its flipping point (i.e. the maximum total utility) at which marginal utility is zero. After the inflection point, total utility decreases at increasing rates and marginal utility becomes negative.  Here we must keep in mind that different goods and services result in different RATES of diminishing marginal utility, for instance, Bottled water might decrease in terms of marginal utility at a rate slower than the change in the marginal utility of chewing gum. Consumer Behavior As we saw, the necessary condition for the consumer’s equilibrium is the equalization of the marginal utilities divided by prices of all goods he consumes.  Thus, the diminishing marginal utility explains how customers allocate their money incomes among many goods and services.  However, utility is restrained by consumer choice and behavior.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 8 Consumer Choice and Budget According to the rational behavior assumption, rational consumers attempt to obtain the greatest amount of satisfaction based on their own choice and their own budget. The choice the consumer makes is mainly induced by his own preferences and taste. But it is not unlimited choices he can make as he wishes, everyone has fixed or limited amount of money income which affects his choices reflecting the assumption of scarcity in resources which is known as “Budget constraint”. Furthermore, every good or service has a price tag must be paid by the consumer to get what he wants which influences his choice. Therefore, the consumer behavior is determined by: 1) Rational behavior. 2) Preferences. 3) Budget constraint. 4) Prices. Due to these constraints, consumers pursue to maximize their total utility by allocating the available budget in a way that maximizes total utility through combining purchases of goods and services.  In other words, choose affordable combinations of goods that makes the sum of the utilities obtained from all goods and services consumed as large as possible.  That is, a consumer must allocate his entire available budget where the last dollar spent on each good yields the same amount of marginal utility, which is represented, as illustrated earlier, by: Example 1: If the apple price is $1 per kg and the price of orange is $2 per kg and the marginal utilities of consuming both are given in the following table How many kilos of apples and oranges will be purchased to attain equilibrium for this consumer if he wants to spend $10 on both goods? Answer apply the rule the utility of the last dollar is 8 utils, We get:  Therefore, this consumer will consume 2 kilograms of apples and 4 kilograms of orange to equilibrate. At this level of consumption, two conditions have been attained, the necessary condition which is reflected in the rule we use besides the sufficient condition which is reflected in the budget constraint where he spent all income, the $10, devoted to purchase apple and orange. That is, 𝑄𝐴apple × 𝑃𝐴apple + 𝑄𝑂range× 𝑃𝑂range = Income Budget Then, 2 × $1 + 4 × $2 = $10  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 9 what is dynamic of this process? according to rationality assumption, the consumer always trying to get the maximum level of satisfaction from every single dollar he spends.  Therefore, when comparing between the utility he gets from the first dollar he pays he find that the utility of the first kilogram of orange provides him with 12 utils for each dollar where the first kilogram of apple gives him only 10 utils, thus he decides to buy the 1st kilogram of orange rather than apple.  After getting his 1st kilogram of orange, he is going to use the same rational logic to spend remaining of his $10 dollars, i.e. the $8.  That is, he will decide to buy his 2nd kilogram of orange as well as his 1st kilogram of apple because both provide him with the same satisfaction of each paid dollar as both goods give him 10 utils for every dollar of the $3 he pays. When comes to the 3rd kilogram of orange and the remaining $5, he gets a satisfaction higher than what he can take from consuming the 2nd kilogram of apple, then he decides to consume the 3rd kilogram of orange and pay $2 for it to be left with $3. Now, if he compares between getting 8 utils to each dollar from purchasing the 4th kilogram of orange and another 8 utils to each dollar from purchasing the 2nd kilogram of apple, he finds himself indifferent. So, what determines either apple or orange? It is the remaining income, which is $3.  Therefore, he chooses to buy both the 2nd kilogram of apple and the 4th kilogram of orange. These dynamics of the final decision of buying a bundle of 4 kilograms of orang and 2 kilograms of apple by spend all devoted budget of $10 is illustrated in the following table: From example, we conclude that every consumer is confronted with endless number of bundles of different goods and services some of which he can afford, and some others he cannot afford.  Moreover, from those zillions of bundles, many of them can give the same level of satisfaction and many others can give higher or lower levels of satisfaction. Thus, the appealing question is how to run the above analysis with those different possibilities, the answer is by using a graphical representation of those possibilities which is known as the indifference curves or the indifference map along with the budget line.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 10 Preferences and Indifference analysis The indifference curve is a line that shows combinations of goods among which a consumer is indifferent.  That is, each point on that curve represents a bundle of goods, and the consumer gets the same level of satisfaction from each one of these bundles therefore he is indifferent regarding which bundle to consume as all of them equal in terms of satisfaction. Figure (3) The indifference curve Assume that Ahmed consumes two goods as he sees films and drink cola every month.  at point C, Ahmed sees 2 films and consumes 6 six-packs of cola every month and gets a certain level of satisfaction.  This level of satisfaction could be attained at point G or any other point on the green curve. Notably, moving from point C to point G entails sacrificing cola to increase films and vice versa, we will discuss later the rates at which this interchange is occurring. Ahmed can classify all possible bundles of goods into three categories, these three categories can be shown graphically as depicted in figure (4) below as: 1) Preferred, the yellow shaded area to the right of the indifference curve. 2) Not preferred, the gray shaded area to the left of the indifference curve. 3) Indifferent, the green line representing the indifference curve. The indifference curve collects all those points that Ahmed says are just as good as point C for him in terms of the satisfaction he gets.  Any point above the indifference curve is preferred to any point on the curve, and any point on the indifference curve is preferred to any point below the curve. the indifference curve shown is just one of many curves that form a consumer’s “indifference map”. The indifference map consists of several indifference curves, each one reflects a different level of satisfaction. As shown in figure (5),  indifference curve below 𝐼2 is preferred to any indifference curve to the left of it such as the indifference curves 𝐼1 and 𝐼0.  Therefore, point 𝐽 on the indifference curve 𝐼2 is preferred to any points 𝐶 & 𝐺 on 𝐼1. Accordingly, every consumer has his own indifference map consisting of an endless number of unique indifference curves presenting different levels of satisfaction. Moving outside against the origin point, the higher the indifference curve, the more preferred the curve. That is, with higher indifference curves the consumer gets more and more of all goods and consequently attains higher satisfaction, as shown in figure (6).  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 11 Features of indifference curves The indifference curves are not likely to be vertical, horizontal, or upward sloping.  That is, a vertical or horizontal indifference curve, as seen in figure (7) panels a and b holds the quantity of one of the two goods (cola and films) constant, implying that the consumer is indifferent to getting more of one good without quitting any of the other good.  An upward-sloping curve, as shown in panel c of figure (7), would mean that the consumer is indifferent between a combination of goods that provides less of everything and another that provides more of everything.  Rational consumers usually prefer more to less. Furthermore, the slope or steepness of indifference curves is determined by consumer preferences. It reflects the amount of one good that a consumer must give up getting an additional unit of the other good while remaining equally satisfied.  This relationship changes according to diminishing marginal utility, which means that the more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin. Indifference curves cannot intersect or overlap. If the curves cross over, it means that the same bundle of goods offers two different levels of satisfaction at the same time.  If the consumer is indifferent to all points on both curves, then the consumer must not prefer more to less. There is no way to sort this out. The consumer could not do this and remain a rational consumer. we conclude that the indifference curves characteristics are: 1) Downward sloping, i.e. not vertical, horizontal, or upward sloping. 2) Convex, i.e. bowed in toward the origin point. 3) Indifference curves cannot intersect or overlap. 4) Curves plotted higher and farther to the right correspond with higher levels of satisfaction.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 12 The marginal rate of substitution MRS the indifference curve 𝐼1 gives the consumer the same level of satisfaction either at point 𝐶 or point 𝐺. When the consumer moves from point 𝐶 or point 𝐺 he forgoes drinking cola and sees more films, which means he substitutes cola by films. The rate at which this substitution will be done is the marginal rate of substitution (MRS) which is the rate at which one good must be added when the other is taken away to keep the individual indifferent between the two bundles. In other words, it reflects the consumer’s willingness to substitute one good for another while maintaining the same level of satisfaction. Example:  when the consumer moves down on the indifference curve from point A to point B, the consumer gives up 4 apples to consume one more orange,  moving from point B to point C the consumer forgoes only 3 apples for an additional unit of orange.  Finally, moving from point C to point D the consumer substitutes 2 apples for another unit of orange. These forgone apples to increase one orange each time in the marginal rate of substituting apples for orange, which can be calculated as: Which can be implemented as: The marginal rate of substitution, is diminishing. That is, as the quantity of orange increases, its marginal utility decreases according to the law of diminishing marginal utility.  Conversely, as the quantity of apple decreases, its marginal utility increases. In fact, the consumer substitutes an increasing marginal utility for a decreasing marginal utility. Therefore, the marginal rate of substitution is diminishing to reflect this fact.  A diminishing marginal rate of substitution is the key assumption of consumer theory.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 13 Geometrically: to find out the marginal rate of substitution at any point on the individual’s indifference curve o we draw a tangent line touching that indifference curve at the wanted point. o Next, we form a right triangle in which the tangent line is the hypotenuse, such as the light blue shaded o triangle in figure (10), o the slope of tangent line is the tan of the chord angle, o the m ⦛ in figure (10), which is the trigonometric ratio between the opposite side and the adjacent side of a right triangle containing that angle: ⦛ ⦛ ⦛ Thus, at point G the marginal rate of substituting cola for films is: 𝑀𝑅𝑆 𝑚⦛ moving down on the indifference curve means decreasing the marginal rate of substitution, why is that? Degree of Substitutability As shown above, the consumer’s indifference curve (IC) reflects the ability of that consumer to switch between goods and services and maintain the same level of utility or satisfaction. we look at the indifference curve as a mirror of the extent to which the relationship between different is. o one good may complement or substitute the other good or goods. o we can recognize the relationship between different goods and services from the appearance of the individual’s indifference curve. The shape of the indifference curves reveals three degrees of substitutability between two goods, these degrees take the following IC shapes: 1) Ordinary goods 2) Perfect substitutes 3) Perfect complements  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 14 Budget Constraint The indifference map, as shown above, only sorts out consumer preferences among bundles of goods. It tells us what the consumer is willing to buy. It does not say what the consumer is able to buy. It does not tell us anything about the consumer’s buying power. Consumption choices to be made by any consumer are constrained by income and prices of the available goods and services. The budget line describes the limits to everybody’s consumption choices as it shows all the combinations of goods that can be purchased with a given level of income. Real Income A consumer’s real income is the income expressed as a quantity of goods he can afford to buy. Figure (11) depicts that Ahmed’s real income in terms of cola is 10 packs, this is the point on his budget line where it intersects the vertical axis at point A. The other way around, Ahmed’s real income in terms of films is 5 films, which is the point on his budget line where it intersects the horizontal axis at point F. If Ahmed’s income is £30, he can spend it all on either cola or films. Therefore, Ahmed’s budget line is the AF line and every other point on that line reflects a bundle of the two goods he can afford. For instance, Ahmed can spend all his income, i.e. the £30, at point E as he can buy 4 films costing £24 as well as 2 cola packs costing £6. All other points like B, C, D, and many others are possible bundles he can afford by spending his total income. Besides, any point inside is still affordable but not all income will be consumed. In contrast, all points outside the budget line are unaffordable to Ahmed. The mathematical expression for budget constraint is: Income = 𝑄𝑥 × 𝑃𝑥 + 𝑄𝑦 × 𝑃𝑥 Where: Income is the devoted amount of money to spend on goods 𝑥 and 𝑦. 𝑄𝑥 the quality bought of good 𝑥. 𝑄𝑦 the quality bought of good 𝑦. 𝑃𝑥 the price of good 𝑥. 𝑃𝑦 the price of good 𝑦. A Change in Income A change in the consumer’s income causes a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change. If income rises, the budget line shifts outside to the right as seen in figure (12) showing that the consumption possibilities have been improved and the consumer can buy more of every good. But, if the income decreases, the budget line shifts parallel to the left reflecting a reduction in the consumer’s consumption possibilities and the consumer will buy less of all goods.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 15 A Change in Price If the price of the commodity on the horizontal axis rises, the affordable quantity of that good falls and the slope of the budget line increases which means the budget line pivots inside on the horizontal axis and it becomes steeper. Inversely, a fall in the price of the commodity on the horizontal axis increases the affordable quantity of that good and decreases the slope of the budget line. That is, falling price makes it possible to buy more of that product with the same amount of income. Thus, the budget line pivots inside on the horizontal axis, and it becomes flatter, as illustrated in figure (13). Consumer Equilibrium The indifference map, combined with the budget line, allows us to determine simultaneously only one bundle of goods or services the consumer wants to purchase, and he can afford. This is how to figure out the consumer equilibrium level of consumption. That is, the consumer equilibrates at a point when his budget line touches the higher indifference curve in his indifference map. At that point: 1) The chosen bundle of the two goods gives the consumer the maximum satisfaction. 2) The consumer has enough money income to pay for that bundle of goods. Graphically, the consumer equilibrates at point C in figure (14) when the budget line touches the highest possible indifference curve 𝐼𝐼1. As such, the consumer spends all his income, i.e. the £30, to purchase 6 units of the six- pack cola and 2 films.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 16 In that case, the first order condition or the necessary condition for the consumer’s equilibrium is attaining the highest possible indifference curve, and the second order condition or the sufficient condition is spending all devoted money income on both goods. At that point, we can notice that the equilibrium occurs when the slope of the budget line equal the slope of the highest indifference curve. In other words, when the slope of the budget line, i.e. the relative price of the two goods, equal the marginal rate of substitution MRS Apple, Orange. Predicting Consumer Behavior As illustrated by figure (14), the consumer’s best affordable point to equilibrate at (i.e. point C): 1) Must be on the budget line. 2) Must be on the highest attainable indifference curve. 3) Has a marginal rate of substitution between the two goods equal to the relative price of the two goods. The consumer can afford to consume more cola and watch fewer films at point F, and he can afford to watch more films and consume less cola at point H, but he is indifferent between F, I and H. Therefore, the consumer obviously prefers C to I. At point F, the consumer’s MRS is greater than the relative price, whereas at point H, his MRS is less than the relative price. But, at point C his MRS is equal to the relative price. Deriving the demand curve As we discussed earlier, if the price of the good on the horizontal axis declines, the affordable quantity of that good increases and the budget line become flatter and vice versa. The effect of a change in the price of a good on the quantity consumed of that good is called the “price effect”. Figure (15) shows that, at point C in panel (a) the quantity consumed is two films at price of £6 each along with 6 six-packs of cola at price of £3 as the devoted income to both goods is £30. Therefore, in panel (b) we can make a point at the price of £6 and quantity 2 of films (i.e. point A). When the price of film falls to £3 the consumer’s budget line pivots outside to intersect the horizontal axis at 10 films (£30 ÷ £3), as shown in panel (c). Accordingly, the new budget line touches a higher indifference curve 𝐼2 at new equilibrium point J at which the purchased quantity of films is 5 at the new price (i.e. the £3). Going down from panel (c) to panel (d), we make point (B) in panel (d) at price £3 and 5 films. The line passes through points (A) and (B) is the “demand curve” for film. Therefore, one can see moving from point (C) to point (J) in panel (3) as an equivalent to moving along down the demand curve of films.  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 17 A Change in Income As we noticed from figure (12), a rise in the consumer’s income causes a parallel outward shift of the budget line enabling the consumer to purchase more films and cola. The effect of that income changes on the quantity of a good consumed is called the “income effect”. Initially, as shown in panel (a) of figure (15), the consumer equilibrates at point J spending his £30 income buying 5 six-packs of cola and watching 5 films because the price of each one is £3, which is reflected in point B on demand curve 𝐷𝐷0 in panel (b).  MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 18 When the consumer’s money income declines to £21, he consumes less cola and see fewer films. That is, the consumer’s budget line shifts leftward parallelly to touches a lower indifference curve 𝐼𝐼1. At the new tangency point K in panel (c), the consumer spends £21 buying three six packs of cola and watching 4 films at price of £3 each. This new consumer equilibrium is reflected in leftward shift of the demand curve from 𝐷𝐷0 to 𝐷𝐷1, and the reduction of film quantity from 5 to 4 is the income effect. Income-Consumption Curve Holding the prices unchanged, an increase in the consumer’s money income induces him to alter his chosen or affordable bundle of the goods. That is, the budget line shifts parallel outward to touch a higher indifference curve. If the income continues to increase, the budget line resumes shifting outside parallel to the initial one. Considering the consumer’s indifference map, with each rightward shift of the budget line, a new tangency point with a higher indifference curve would be created. The line that connects those tangency points is called the Income-Consumption Curve as shown in figure (16) below. Figure (16) shows the pathway at which the consumer’s equilibrium levels are attained with each increase in his income. The initial equilibrium occurs at point A when the initial budget line touches the indifference curve 𝐼𝐼1. With constant prices and increasing money income, budget line shifts parallel outside to the purple line touching a higher indifference curve 𝐼𝐼2 at point B. a further increase in the consumer’s income shifts his budget line once again to the right, i.e. the green line, touching a higher indifference curve 𝐼𝐼3 at point C and so on …., the line passes through A, B, and C is the Income-Consumption curve. MOSTAFA NOR-EL DIN Economic Analysis BIS section (3) 19