Lecture 11. The Theory of Demand.pdf - Price changes Income and Substitution Effects Consumer Surplus Market Demand Economics Lesson 11 Consumer theory

# Lecture 11. The Theory of Demand.pdf - Price changes Income...

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Price changes Income and Substitution Effects Consumer Surplus Market Demand Economics - Lesson 11 Consumer theory The Theory of Demand Anna D’Ambrosio Polythecnic of Turin Chapter 5,Besanko & Braeutigam, Microeconomics , 4th Edition 1 / 48

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Price changes Income and Substitution Effects Consumer Surplus Market Demand Demand Theory 1 Price changes 2 Income and Substitution Effects 3 Consumer Surplus 4 Market Demand 2 / 48
Price changes Income and Substitution Effects Consumer Surplus Market Demand Price Changes and Individual Demand The optimal consumption bundle tells us how much of good x a consumer will demand at a given price level P x We can find more points on her demand curve by repeating the exercise for different prices of x , asking what the monthly consumption of good x will be if the price is p x 1 , p x 2 , p x 3 . In other words, a change in the price can inform us about the demand curve of a good. For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves 3 / 48

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Price changes Income and Substitution Effects Consumer Surplus Market Demand Price Changes and Individual Demand Optimal choice Individual Demand 4 / 48
Price changes Income and Substitution Effects Consumer Surplus Market Demand Effect of a Price Change From the previous example: P Q \$4.00 2 \$2.00 10 \$1 16 The curve connecting all baskets that are optimal as the price of good x changes is the price consumption curve , or price expansion path Notice that the consumer is better off (i.e. on higher indifference curves) as the price of the good falls By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual A decrease in the price of x causes the consumer to move down and to the right ALONG the demand curve. 5 / 48

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Price changes Income and Substitution Effects Consumer Surplus Market Demand From Optimal Choice to Demand At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing The demand curve can be thought as representing a consumer’s willingness to pay for an additional unit of the good: This is implicit in the MRS: At point A, MRS=1, hence a unit of food is worth 1 unit of clothing, which costs \$4. Hence the consumer is willing to pay \$ 4 for an additional unit of food. At point B, MRS=1/2, hence a unit of food is worth 1/2 unit of clothing, which costs \$4. Hence the consumer is willing to pay \$ 2 for an additional unit of food. The willingness to pay for a good decreases as the quantity consumed increases 6 / 48
Price changes Income and Substitution Effects Consumer Surplus Market Demand Effect of a Price Change 7 / 48

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Price changes Income and Substitution Effects Consumer Surplus Market Demand Income Changes Recall that an increase in income results in an outward, parallel shift of the budget line.
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