Microeconomics - BS1551 - 1.4 - Individual and Market Demand
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Course
Microeconomics (BS1551)
Institution
Cardiff University (CF)
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Microeconomics – BS1551 - Individual and market demand
Applying what we know
In rational consumer choice, we developed a framework for predicting consumer behaviour
and it turned out to be based on Marginal Benefit v Marginal Cost.
This week, we are going to apply what we know and ask: How does the consumer react
when things change? (Exogenous factors)
In the previous week, we saw how changes in price and income affect the budget constraint.
Here, we will see how changes in the budget constraint affect actual purchase decisions.
Changes in price 1: the PCC and individual demand
The diagram above shows a consumer who is choosing between food and shelter:
- B0 is the budget constraint which shows all the consumption bundles of food and
shelter which spends the consumer's entire income.
- The bundle which gives the highest utility can be found on I0.
- Therefore, the bundle that will be chosen will be the point where the touch lines
touch and is the point S0.
A fall in the price of shelter
- If the consumer is consuming food only, then a fall in the price of shelter will not
affect the consumer's choice and the y-intercept will stay the same.
- If the consumer is consuming shelter only, then a fall in the price of shelter will allow
them to consume more.
- This can be seen diagrammatically by the budget curve pivoting outwards.
- The indifference curve I0 is now not the optimum indifference curve as there would
be indifference curves that lie above this one which would offer higher utility whilst
still being on or beneath the budget constraint. Referring back to the previous
lecture, we are not maximising utility unless the budget constraint is tangent to the
indifference curve.
, - The gradient of the budget constraint is now also less steep, representing that the
marginal cost of shelter has gone down. Now the marginal cost has fallen compared
to the marginal benefit it is likely we will increase our consumption.
- The new indifference curve is shown below:
The indifference curve I1 was previously unaffordable but is now affordable to the
consumer so they will choose it as it provides higher utility.
There appear to be two effects going on:
1. The higher budget constraint allows the consumer to buy more food and shelter.
2. The lower relative price of shelter reduces the marginal cost of shelter in terms of
foregone food.
This is done again below:
This graph shows the price of shelter gradually decreasing and the different price levels of
shelter. We know that it is a change in the price of the shelter because it is pivoting around
the y-axis, the y-intercept doesn’t change.
Out of all of these indifference curves, the one that offers the highest utility is I3.
PCCs line is called the price consumption curve for shelter.
- Definition: The price-consumption Curve indicates the various amounts of a
commodity bought by a consumer when its price changes.
, The price-consumption curve
If you hold the income and the price of food constant, the price-consumption curve for
shelter traces how the best affordable bundle changes as the price of shelter changes.
As the price of shelter fell, the quantity of shelter that the consumer bought increased. This
can be plotted.
The graph shows the different quantities of shelter consumed at different price levels and
different consumption bundles.
The graph is showing a relationship between the price of shelter and the amount of shelter
the consumer wants to consume.
The downward-sloping curve is known as the individual demand curve.
- Definition: The individual demand curve shows the relationship between the
quantity of a good a single consumer is willing to buy and its price.
Horizontal interpretation
At each price of shelter, we worked out the quantity of shelter she demanded, and each
price was associated with a different budget constraint.
We then constructed the consumer's individual demand curve using the horizontal
interpretation.
Changes in income: The ICC and the Engel Curve
An increase in income
The original line is I0 and B0. This line represents the original budget constraint and the
indifference curve that provides the highest utility that can be consumed within this
indifference curve.
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