Microeconomics analyses the decision making by individual consumers/firms/investors. The key
underlying assumption is that of ceteris paribus.
Ceteris paribus means: keeping all other factors constant. .When you zoom in on one particular
market in micro-economics, you assume that
1. All other markets and the economy at large will remain undisturbed by what happens in ‘our’
market
2. Income, tastes, technology of production and other prices do not change
Supply is a positive function of price, whereas demand is a negative function of price. Equilibrium will
be reached when both are equal and the market will always try to do so by the invisible hand.
The key assumptions which underly the neoclassical theory of demand are:
1. Methodological individualism: the unit of analysis is the representative consumer: the
summation of all individual consumers.
2. Instrumental rationality: consumers spend their income in such a way that they attain the
highest satisfaction/utility.
3. Complete knowledge/perfect information: to maximize utility.
4. Utility is ordinal: consumers rank their preferences according to utility.
5. Consistency of choice: it is assumed that the representative consumer is consistent in their
choice.
6. Diminishing marginal utility: it is assumed that the utility gained from previously consumed
goods diminishes. When thirsty, 1st glass of water gives more utility than the 5th.
7. Consumer sovereignty: consumers use their spending power as ‘votes’ for goods. Also
external marketing etc do not change the fundamental preferences of consumers.
The utility function has to satisfy 2 conditions:
1. The first derivative = the marginal utility, is always > 0. Or ‘more is always better’. This is also
called the first postulate.
2. The second derivative = Law of diminishing marginal utility, is always < 0. When thirsty, 1st
glass of water gives more utility than the 5th. This is also called the second postulate.
An indifference curve is the combination of points which yield the same level of utility to the
consumer, so that he is indifferent in what he consumes. The indifference curve has a negative slope,
which denotes that if less of q1 is consumed, more of q2 is needed for the same utility.
The marginal rate of substitution (MRS) of q1 for q2 is defined as the number of units of q2 that
must be sacrificed for 1 extra unit of q1, so that the consumer remains at the same level of utility.
A set of indifference curves is called an indifference map. Indifference curves can never intersect.
Consumers aim for maximum utility, however they are constraint by their budget. Everything on and
below the budget line can be bought. In this theory however, since a consumer always maximizes
utility, purchases are ON the budget line.
At the point of tangency of the budget line to an indifference line, there is maximum utility.
,The budget line changes in the following way:
• If the income of the consumer rises, the budget line shifts up and right
• The price of good 1, P1 declines, but P2 remains the same. This will change the slope of the
budget line. A lower price means at 0 P2, more of P1 can be bought, so the intersection with
the axis of P1 shifts up.
The above figure shows 3 important things:
• The lower price P1 raises the demand for good 1: quantity bought increases as price falls
• The income effect occurs if commodity 1 becomes cheaper and thereby increases the
purchasing power at the same income. Lower price P1 increases demand for commodity 2 as
well = income effect.
• The cross-price effect: the lower price P1 increases the demand for commodity 2, therefore
the goods are not substitutes, but complementary goods.
The total price effect can be split into 2 separate effects:
1. The substitution effect, which is the increase in quantity bought as the price falls, by forcing
the consumer to remain on the original indifference curve
2. The income effect, which is the increase in quantity bought as the price falls, due to higher
purchasing power
To decompose the total price effect into the substitution and income effect, the following steps must
be taken:
• We force the consumer to remain on the original indifference curve/same utility level as
before price change
• Shift the new budget line downwards, until new tangent point is reached, compensating
variation, resulting in point A”
• The movement from A to A” shows the substitution effect
• A” does not constitute a new optimum, there is a higher purchasing power and A” is shifted
to B on the highest reachable indifference curve: the income effect
,The substitution effect of a decline in P1 on the quantity demanded q1 of good 1 is always negative,
because q1 increases. Quantity demanded q2 of good 2 is positive, because q2 decreases.
Ways in which the demand for good 1 can increase:
• When the price of good 1 falls
• When the price of good 2 rises
• When consumer income rises
The stylized findings of consumer behavior can be summarized to:
• The income elasticity of demand
• The own-price elasticity of demand
• The cross-price elasticity of demand
The income elasticity of consumer demand is defined as the proportionate change in the quantity
demanded of a particular good, resulting from a proportionate change in the income of consumers.
The observed income elasticities of demand are different for different classes of goods & services.
The following classes can be distinguished:
A normal good is considered a necessity if its income elasticity of demand is less than unity and
luxury of its more than unity. Some examples include:
, • eY ≈ 0.2-0.4 for household energy demand. If household income rises by 10%, demand will
rise less than proportionally by 2-4%. Households do not want to reduce energy
proportionate, since energy is a necessity
• eY ≈ 0.4 for the demand for healthcare, rises less than proportionally
• eY ≈ 0.2 demand for basic essential food AND beer/wine due to addictiveness
• eY ≈ 1.2 for air travel or new kitchens
• eY ≈ 1.5 for luxury cars/electric vehicles
• eY ≈ -0.3 for second-hand goods
• eY ≈ -0.2 for fast-food from limited service restaurants or inter-city buses
The negative elasticity of inferior goods does not mean they are inferior, but that their demand
decreases for richer households.
The observed price elasticities of demand also have different classes for different goods:
If eP = 0 the demand for that good is perfectly inelastic. If -1≤ eP ≤ 0 the demand for this good is
inelastic. If eP < -1, the demand for that good is elastic, these are general luxury goods.
• eP = -0.2/-0.4 for the demand for health case, this means that if the price of health care is
raised by 10%, demand will only decline with 2-4%
The increase in price for a Giffen good will lead to an increase in demand for this good.
For normal goods, the cross-price elasticity is negative if x and z are complementary goods and
positive if they are substitutes. The higher the value of eXZ the stronger the degree of substitutability
or complementarity between x and z.
The bandwagon effect is the increase in demand due to the fact that others are also consuming the
same commodity, in order to conform with the people they want to be associated with
A major critique of the neoclassical theory of demand is that there’s no consumer sovereignty, but
consumer dependency instead. There are 3 theories about this, from 3 social scientists:
THORSTEIN VEBLEN: conspicuous consumption
Thorstein Veblen proposed that consumer spending is driven by relative status considerations. His
theory of the leisure class is that the best-off members in a community, the leisure class, establish
the standards for the rest. Their wasteless, useless and non-productive or conspicuous consumption
is something the lower class aspire.
This consumption leads to Veblen goods: a status good for which the demand increases as the price
increases, in contradiction with the law of demand. The quantity demanded decreases as the price
lowers. However if the price decreases below P*, it becomes a normal good.
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