Rational Consumer Choice
1.The model of Rational Consumer Choice takes consumer preferences as given and assumes they will try and satisfy them in the most efficient way possible.
2.The first step in solving the budgeting problem is to identify the set of bundles of goods that the consumer is able to buy. The consumer is assumed to have an income level given in advance and to face fixed prices. Prices and income together define the consumer’s budget constraint, which in the simple two-good case, is a downward-sloping line whose slope, in absolute value, is the ratio of the two prices. It is the set of all possible bundles that the consumer might purchase if he spends his entire income.
3.The second step in solving the consumer budgeting problem is to summarise the consumers preferences. Here, we begin with a preference ordering by which the consumer is able to rank all possible bundles of goods. This ranking scheme is assumed to be complete and transitive and to exhibit the more is better property. Preference orderings that satisfy these restrictions give rise to indifference maps, or collections of indifference curves, each of which represents combinations of bundles among which the consumer is indifferent. Preference orderings are also assumed to have diminishing marginal rate of substitution in the sense that if you have pepsi on the y-axis and pizza on the x axis then for a lot of pepsi and less of pizza the consumer will be willing to give up a lot of pepsi for a unit extra of pizza, and when there is a lot of pizza and a little bit of pepsi the consumer will require a lot more of pizza for giving up an unit of pepsi.
4. The budget constraint tells us what combinations of goods the consumer can afford to buy. To summarise the consumer’s preferences over various bundles, we use an indifference map. The best affordable bundle occurs at a point of tangency between an indifference curve and the budget constraint. At that point, the marginal rate of substitution is exactly equal to the rate at which the goods can be exchanged for one another at market prices.
Individual and Market Demand
- How do individual and market demands respond to variation in prices and incomes. To generate a demand curve for an individual consumer for a specific good X, we first trace out the price-consumption curve in the standard indifference curve diagram. The PCC is the line of optimal bundles observed when the price of X varies, with both income and preferences held constant. We then take the relevant price-quantity pairs from the PCC and plot them in a separate diagram to get the individual demand curve.
- The Income analog to the PCC is the income consumption curve, or ICC.It too is constructed using the standard indifference curve diagram.The ICC is the line of optimal bundles traced out when we vary the consumer’s income, holding preferences and relative prices constant. The Engel curve is the income analog to the individual demand curve.We generate it by retrieving the relevant income-quantity pairs from the ICC and plotting them in a separate diagram.
- Normal goods are those which a consumer buys more of when income increases and inferior goods are those the consumer buys less of as income rises.
- The total effect of a price change can be decomposed into two separate effects:1) the substitution effect, which denotes the change in quantity demanded that results because the price change makes substitute goods seem either more or less attractive, and 2) the income effect, which denotes the change in quantity demanded that results from the change in real purchasing power caused by the price change. The substitution effect always moves in the opposite direction from the movement in price: price increases (reductions)always reduce(increase)the quantity demanded. For normal goods, the income effect also moves in the opposite direction from the price change, and thus tends to reinforce the substitution effect. For inferior goods, the income effect moves in the same direction as the price change, and thus tends to undercut the substitution effect.
- The fact that the income and substitution effects move in opposite directions for inferior goods suggests the theoretical possibility of a Giffen good, one for which the total effect of a price increase is to increase the quantity demanded.
- Goods for which purchase decisions respond most strongly to price tend to be ones that have large income and substitution effects that work in the same direction. For example, a normal good that occupies a large share of total expenditures and for which there are many direct or indirect substitutes will tend to respond sharply to changes in price. For many consumers, housing is a prime example of such a good. The goods least responsive to price changes will be those that account for very small budget shares and for which substitution possibilities are limited. For most people, salt has both those properties.
- A central analytical concept in demand theory is the price elasticity of demand, a measure of the responsiveness of purchase decisions to small changes in price. Formally, it is defined as the percentage change in quantity demanded that is caused by a one percentage change in price. Goods for which the absolute value of elasticity exceeds 1 are said to be elastic; those for which it is less than 1, inelastic; and those for which it is equal to 1, unit elastic.
- Another important relationship is the one between price elasticity and the effect of a price change on total expenditure. When demand is elastic, a price reduction will increase total expenditure; when inelastic, total expenditure falls when the price goes down. When demand is unit elastic; total expenditure is at a maximum.
- The value of the price elasticity of demand for a good depends largely on four factors: substitutability, budget share, direction of income effect, and time.1) Substibutabiility. The more easily consumers may switch to other goods, the more elastic demand will be.2)Budget share. Goods that account for a large share of total expenditures will tend to have higher price elasticity.3)Direction of income effect .Other factors the same, inferior goods will tend to be less elastic with respect to price than normal goods.4) Time. Habits and existing commitments limit the extent to which consumers can respond to price changes in the short run. Price elasticity of demand will tend to be larger, the more time consumers have to adapt.
- Changes in the average income level in the market will generally shift the market demand curve. The income elasticity of demand for a good X is defined analogously to its price elasticity.It is the percentage change in quantity that results from a one percentage change in income. Goods whose income elasticity of demand exceed zero are called normal goods, those for which it is less than zero are called inferior goods;those for which it exceeds one are called luxuries; and those for which it is less than one are called necessities. For normal goods an increase in income will shift market demand to the vright; and for inferior goods, an increase in demand will shift it to the left. For some goods, the distribution of income, not just its average value, is an important determinant of market demand.
- The cross price elasticity of demand is a measure of the responsiveness of the quantity demanded of one good to a small change in the price of another.If cross price elasticity is positive the goods are substitutes and if negative, complements.