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Unformatted text preview: Chapter 4 Analysis of Demand Now that we have a formal apparatus for studying consumer decisions, we can begin to apply it to the study of consumer choices. A leitmotif of this chapter is derivation of the implications of the presence of the utility function for things we can actually see; by this I mean quantities that are observable, such as the consumers income, prices of various goods, and the consumers choices at these prices and income. One of the most insightful and useful things that can be done with the aid of utility theory is the decomposition of demand into income and substitution effects . Understanding how these two effects interact is really the key to understanding how consumer demand works. One lesson gained from thinking about income and substitution effects is that consumers may respond to price changes in rather diverse and unexpected ways. To get some of the main ideas in place, I will start with a hypothetical situation. Suppose that Jimmy is a graduate student commuting to college every day. Jimmy uses public transportation to commute. One day, the Metropolitan Transit Authority doubles bus and subway fares. The (seem- ingly simple) question: how does Jimmy respond to this change in price? The qualitative answer to the question requires little microeconomic the- ory to explain. If the price of a given good or service rises, we know that the consumers demand for the good or service should fall. Thus, virtually any- one would predict that Jimmy should respond to the fare change by riding 103 104 CHAPTER 4. ANALYSIS OF DEMAND the bus and/or subway less often. In fact, a solid quantitative estimate as to how Jimmys behavior has changed due to the fare hike might be available: maybe Jimmy used to commute by transit 5 times a week, and now, after the fare change, only uses transit 4 times a week. By way of gaining some insights into how Jimmy has been impacted by this change, lets expand the story a bit. Suppose that Hunter College sub- sidizes commuting expenses for graduate students, and, accordingly, Jimmy receives some funds to cover commuting costs. Obviously, Jimmy is going to need a bigger stipend to cover costs after the fare increase, but the ques- tion is: how much more money? A logical guess is that, since the fare has doubled, the stipend should be doubled. 1 But this turns out to be wrong, and will make Jimmy better off than he was before the fare change! You might not believe this, but I will show you why twice as much money is too much. In the process of finding out how much money Jimmy should actually receive, we will also learn a little something about the utility in monetary terms you derive from use of the transit system. Really, what we are going to do is figure out the substitution effect and the income effect deriving from a change in a goods price. While the example presents the ideas in a practical setting, the best way to think about what we shall do next in general terms is as a thought experiment that can be carried out in any...
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- Fall '09