Unit 5. Tastes and Demand Choice. Economics - 6th year EURSC 2007/2008. Economics - 6th year (EURSC) Unit / / 23

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1 Unit 5 Tastes and Demand Choice Economics - th year EURSC 007/00 Economics - th year (EURSC) Unit 5 007/00 1 / 3 Contents 1 Introduction Consumer Tastes 3 Consumer Choice The Demand Economics - th year (EURSC) Unit 5 007/00 / 3

2 Introduction We now how to represent the budget set given prices and income Which of these will choose an individual? Obviously, the most preferred Individual preferences are modelled through indifference curves Indifference curves: the set of consumption bundles which are indifferent to an individual Economics - th year (EURSC) Unit 5 007/00 3 / 3 xioms on Tastes To represent Indifference Curves we need to make some assumptions 1 Consumer can rank the different bundles according to satisfaction The consumer prefers more to less 3 Transitivity: if a bundle is indifferent to and is indifferent to C then is indifferent to C. Economics - th year (EURSC) Unit 5 007/00 / 3

3 Properties of Indifference Curves The above three assumptions imply that indifference curves are: Decreasing (proof) The higher the curve, the higher the satisfaction (proof) Can not cross each other (proof) Indifference curves are also continuous. (not proof) Economics - th year (EURSC) Unit 5 007/00 5 / 3 Cinema Higher curves mean higher satisfaction 1 Decreasing Utility Preferred Region Dominated Region C Increasing Utility

4 Cinema 1 Indifference curves are decreasing Preferred Region Dominated Region C Indifference Curve Cinema Indifference curves do not cross 1 C

5 Rate of Substitution and Convexity Rate of substitution: the maximum number of units of Y you would like to give for an additional unit of X.... or the minimum number of Y you ask to receive for giving up 1 X. In the limit, rate of substitution is the increment ratio, i.e., the slope of the indifference curve We assume a new additional xiom: Rate of substitution is decreasing. Thus, Indifference Curves are convex (proof) Economics - th year (EURSC) Unit 5 007/00 9 / 3 Cinema Indifference curves are convex 1 C

6 Solution We have the elements for finding individual choice The budget restriction: represents bundles which are affordable The Map of indifference curves: represents tastes est Choice: the bundle in the restriction that maximizes utility Graphically: the point where indifference curve is tangent to budget line Economics - th year (EURSC) Unit 5 007/00 11 / 3 Cinema 1 C

7 Economic Interpretation The slope of the IC is the (marginal) rate of substitution. The slope of the udget Line is the rate at which market exchanges X per Y If not equal. the individual will go on doing exchange Slope IC > Slope L uy more X, sell Y Slope IC < Slope L Sell more X, buy Y Solution: equilibrium is reached when both coincide (marginally, principle #3) Economics - th year (EURSC) Unit 5 007/00 13 / 3 Factors of demand The quantity demanded of a good changes when: Changes in income Changes in own price Changes in other goods prices Changes in preferences Economics - th year (EURSC) Unit 5 007/00 1 / 3

8 Demand and Income If income increases, not always demand increases Normal good: demand increases with income Inferior good: demand decreases with income good is normal or inferior depending on preferences, not in the nature of good. (possibly) Inferior Good The demand for shoe-repair services may be for many an inferior good, since people tends to buy new shoes rather than repairing as they get richer. Economics - th year (EURSC) Unit 5 007/00 15 / 3 Cinema as a Normal Good

9 Cinema as an Inferior Good Changes in Own Price When price increases, there are two effects in the budget line The Effect on Relative Price The Effect on Income The corresponding effects for demand are called: Substitution Effect: Change in demand due to change in relative prices Income Effect: Change in demand due to change in real income Substitution Effect is always negative. Income effect may be negative or positive, depending on normal or inferior good. Economics - th year (EURSC) Unit 5 007/00 1 / 3

10 Cinema n Increase of Price of 1 Substitution effect Income Effect Demand and Price When the price of a good increases 1 For substitution effect, demand reduces For income effect: Normal good: Demand reduces Inferior good: Demand increases For normal good, price increases, demand reduces For inferior good, if the income effect is smaller than substitution effect finally, demand reduces if the income effect is bigger than the substitution effect finally, demand may increase. (Giffen good) Economics - th year (EURSC) Unit 5 007/00 0 / 3

11 The Price of Other Goods When the price of other goods increase Substitute: the demand of the good increase Complements: the demand of the good reduces (Possibly) substitute goods lack pens and blue pens are almost perfect substitutes. If the price of blue pens increases, many consumers will tend to replace blue pens with black pens, and demand of black pens will increase. (possibly) complement goods New electronic gadgets like Digital cameras, mp3 and rechargeable batteries are complementary. s the price of these devices has been decreasing, the demand for rechargeable batteries has expanded. Economics - th year (EURSC) Unit 5 007/00 1 / 3 Cinema 1 and Cinema are Substitutes

12 Cinema 1 and Cinema are Complements

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