chapter 2 demand and supply analysis: consumer demand presenter’s name presenter’s title dd...
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CHAPTER 2DEMAND AND SUPPLY ANALYSIS: CONSUMER DEMANDPresenter’s namePresenter’s titledd Month yyyy
Copyright © 2014 CFA Institute 2
1. INTRODUCTION
Build the model with simplifying
assumptions
Develop the implications of
the model
Compare the model’s
implications with the real
world
The development process of an economic model
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2. CONSUMER THEORY: FROM PREFERENCES TO DEMAND FUNCTIONS
• Consumer choice theory is the part of economics in which we focus on consumer demand and consumer preferences.
- It addresses consumers’ tastes and preferences.
- It examines the trade-offs that consumers make between or among goods.
- It delves into the choices consumers make, given a set of prices, when consumers have limited income.
- The limit on income is the budget constraint.
• Models of consumer choice:
- Do not seek to explain why consumers have the tastes and preferences that they have, but rather why they make the choices they do given their tastes and preferences.
- Focus on the aggregate behavior of consumers, not that of an individual consumer.
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3. UTILITY THEORY: MODELING PREFERENCES AND TASTES
• The consumption bundle (or consumption basket) is the set of goods and services that the consumer would like to consume.
• Axioms of the theory of consumer choice:
1. We assume that a consumer can make a choice between any two bundles—the assumption of complete preferences.
- The consumer prefers one to another or is indifferent between the two.
- We refer to this as complete preferences: Consumers are able to make comparisons and choices.
2. We assume that consumers’ preferences are transitive preferences.
- If a consumer prefers Bundle A to Bundle B and prefers Bundle B to Bundle C, then the consumer prefers A to C if preferences are transitive.
3. We assume that there is nonsatiation for at least one good.
- There is never too much of that good.
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THE UTILITY FUNCTION
• We represent a consumer’s preferences using a utility function.
• A utility function is a representation of the satisfaction that a consumer receives from a basket of goods or services.
- The utility of a basket is measured in utils, which represent the ranking of the utility of the goods and services:
where
is quantity of good or service i in the bundle
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INDIFFERENCE CURVES
• We can represent preferences with indifference curves, which represent the utility of each possible combination of a given set of goods and services.
- Because the utility is the same throughout a given curve, the consumer is indifferent between the combinations on a curve.
• The marginal rate of substitution is the rate at which a consumer will give up one good or service in exchange for another and still have the same utility.
• The indifference curve map is a graphical representation of the possible indifference curves, one for each level of utility.
Good A
Goo
d B
Curve 1
Curve 1
Curve 3
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4. THE OPPORTUNITY SET: CONSUMPTION, PRODUCTION, AND INVESTMENT CHOICE
• The budget constraint (also known as the income constraint) is what can be bought based on a set of prices of goods and income.
• Consider two goods: Good 1 and Good 2. The budget constraint is
where
is the price of Good 1
is the quantity of Good 1
is the price of Good 2
is the quantity of Good 2
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PRODUCTION FUNCTION AND INVESTMENT OPPORTUNITY SET
• The production opportunity frontier represents the different quantities of two goods that a company can produce, considering the trade-off between the two goods in terms of manufacturing facilities.
- Analogous to the budget constraint for a consumer.
• The investment opportunity set is the set of investment opportunities that an investor may invest in.
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5. CONSUMER EQUILIBRIUM: MAXIMIZING UTILITY SUBJECT TO THE BUDGET CONSTRAINT
Indifference curve 1Indifference curve 2Indifference curve 3
Good 1
Go
od
2
• Consumers prefer more utility to less and thus will want the bundles of goods that maximize utility, given the budget constraint.
• Looking at a his or her utility function, the consumer will choose the bundle of goods that maximizes the utility (the indifference curve farthest from the origin) within a given budget constraint.
Step 1
• Determine the consumer’s preferences (utility).
Step 2
• Determine the budget constraint.
Step 3
• Determine the bundle of consumer goods that maximizes utility given the budget constraint.
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NORMAL VS. INFERIOR GOODS
• A normal good is a good that a consumer buys more of with increases in income.
• An inferior good is a good that a consumer buys less of with increases in income.
• Income effects:
- As income increases, the consumer has a larger budget, and therefore, the optimal bundle changes, resulting in a higher proportion of the normal good and a lower proportion of the inferior good.
• Substitution effect:
- Substitution effects are movements along an indifference curve.
- Substitution with income effects: If one of the prices changes (relative to the price of another), the budget line changes slope and the new bundle of goods is along the same indifference curve, but a different bundle (tangent to new line).
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6. REVISITING THE CONSUMER’S DEMAND FUNCTION
Change in real income without price changes
Parallel shift in the budget line
Change in real income from a price change
Change in the slope of the budget line
Substitution without any
change in real income
Movement along the
indifference curve
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INCOME AND SUBSTITUTION EFFECTS
Income effects:• When income rises, the
demand for normal goods increases.
• When income rises, the demand for inferior goods falls.
Quantity of Inferior Good
Qua
ntity
of N
orm
al G
ood
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BREAKING DOWN INCOME AND SUBSTITUTION EFFECTS
• A change in the price of a good will result in a change in the real income of the consumer.• The change in demand from this change is
the substitution effect.• A change in income results in an
• increased demand for normal goods, and a• decreased demand for an inferior good.
Quantity of Inferior Good
Qua
ntity
of
Nor
mal
Goo
d
CA
B
When the price of an inferior good falls, the budget constraint pivots upwardSubstitution effect = QB – QA Income effect = QC – QB
QA QB QC
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SPECIAL CASES OF DEMAND
• A Giffen good is an inferior good for which the income effect outweighs the substitution effect.
- Lowering the price of a Giffen good will result in a decrease in its demand.
- Raising the price of a Giffen good will result in an increase in its demand.
- A Giffen good is an inferior good, but not all inferior goods are Giffen goods.
- There are few Giffen goods.
• A Veblen good is a good for which the demand increases as the price of the good increases.
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7. CONCLUSIONS AND SUMMARY
• Consumer choice theory and utility theory help us understand consumer preferences.
• A consumer’s marginal rate of substitution represents the rate at which the consumer will trade one good for another.
• What a consumer can spend (i.e., the budget) depends on the consumer’s income, and what a consumer buys depends on the prices of goods and the consumer’s preferences (i.e., utility).
• A consumer’s equilibrium is the point of tangency between the consumer’s budget and marginal rate of substitution.
• We can break down changes in demand related to income and substitution effects.
- The income effect is the response in demand for a good when income changes.
- The substitution effect is the response in demand for a good when the relative prices of goods change.
- When relative prices change, there may be both an income effect (i.e., change in real income) and a substitution effect.
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7. CONCLUSIONS AND SUMMARY
• A normal good is a good whose demand increases when income increases (and falls when income falls).
- A Veblen good has a perverse demand: The more is demanded of the good, the higher the price of the good.
• An inferior good is a good that generally has a decrease in demand as income increases.
- An extreme case of an inferior good is a Giffen good, for which an increase in price results in an increase in demand.