Lesson 4: Consumer Behavior

1. Uncertainty
2. Market Demand
3. Market equilibrium
 1. Uncertainty
Uncertainty is Pervasive
 What is uncertain in economic
systems?
– tomorrow’s prices
– future wealth
– future availability of commodities
– present and future actions of other
people.
 Uncertainty is Pervasive
 Whatare rational responses to
uncertainty?
– buying insurance (health, life, auto)
– a portfolio of contingent
consumption goods.
 States of Nature
 Possible states of Nature:
– “car accident” (a)
– “no car accident” (na).
 Accident occurs with probability a,
does not with probability na ;
a + na = 1.
 Accident causes a loss of $L.
 Contingencies
A contract implemented only when a
particular state of Nature occurs is
state-contingent.
 E.g. the insurer pays only if there is
an accident.
 Contingencies
A state-contingent consumption plan
is implemented only when a
particular state of Nature occurs.
 E.g. take a vacation only if there is no
accident.
 State-Contingent Budget
Constraints
 Each $1 of accident insurance costs .
 Consumer has $m of wealth.
 Cna is consumption value in the no-
accident state.
 Ca is consumption value in the
accident state.
 State-Contingent Budget
Constraints
Cna

A state-contingent consumption
with $17 consumption value in the
20 accident state and $20 consumption
value in the no-accident state.

17 Ca
 State-Contingent Budget
Constraints
 Without insurance,
 Ca = m - L
 Cna = m.
 State-Contingent Budget
Constraints
Cna

The endowment bundle.

m

mL Ca
 State-Contingent Budget
Constraints
 Buy $K of accident insurance.
 Cna = m - K.
 Ca = m - L - K + K = m - L + (1- )K.
 So K = (Ca - m + L)/(1- )
 And Cna = m -  (Ca - m + L)/(1- )
 I.e. m  L 
Cna   Ca
1 1
 State-Contingent Budget
Constraints
Cna m  L 
Cna   Ca
1 1
The endowment bundle.
m

 Where is the
slope   most preferred
1 state-contingent
consumption plan?
mL m  L Ca

 Preferences Under Uncertainty
 Think of a lottery.
 Win $90 with probability 1/2 and win
$0 with probability 1/2.
 U($90) = 12, U($0) = 2.
 Expected utility is
1 1
EU   U($90)   U($0)
2 2
1 1
  12   2  7.
2 2
 Preferences Under Uncertainty
 Think of a lottery.
 Win $90 with probability 1/2 and win
$0 with probability 1/2.
 Expected money value of the lottery
is 1 1
EM   $90   $0  $45.
2 2
 Preferences Under Uncertainty
 EU = 7 and EM = $45.
 U($45) > 7  $45 for sure is preferred
to the lottery  risk-aversion.
 U($45) < 7  the lottery is preferred
to $45 for sure  risk-loving.
 U($45) = 7  the lottery is preferred
equally to $45 for sure  risk-
neutrality.
 Preferences Under Uncertainty
U($45) > EU  risk-aversion.
12 MU declines as wealth
U($45) rises.

EU=7

$0 $45 $90 Wealth

 Preferences Under Uncertainty
U($45) < EU  risk-loving.
12 MU rises as wealth
rises.

EU=7
U($45)
2

$0 $45 $90 Wealth

 Preferences Under Uncertainty
U($45) = EU  risk-neutrality.
12 MU constant as wealth
rises.
U($45)=
EU=7

$0 $45 $90 Wealth

 Preferences Under Uncertainty
 State-contingent consumption plans
that give equal expected utility are
equally preferred.
 Preferences Under Uncertainty
Cna Indifference curves
EU1 < EU2 < EU3

EU3
EU2
EU1
Ca
 Preferences Under Uncertainty
 What is the MRS of an indifference
curve?
 Get consumption c1 with prob. 1 and
c2 with prob. 2 (1 + 2 = 1).
 EU = 1U(c1) + 2U(c2).
 For constant EU, dEU = 0.
 Preferences Under Uncertainty
EU   1U(c1 )   2U(c 2 )

dEU   1MU(c1 )dc1   2MU(c 2 )dc 2

dEU  0   1MU(c1 )dc1   2MU(c 2 )dc 2  0

  1MU(c1 )dc1   2MU(c 2 )dc 2

dc 2  1MU(c1 )
  .
dc1  2MU(c 2 )
 Preferences Under Uncertainty
Cna Indifference curves
EU1 < EU2 < EU3

dcna  a MU(ca )

dca  na MU(cna )
EU3
EU2
EU1
Ca
 Choice Under Uncertainty
 Q: How is a rational choice made
under uncertainty?
 A: Choose the most preferred
affordable state-contingent
consumption plan.
 State-Contingent Budget
Constraints
Cna m  L 
Cna   Ca
1 1
The endowment bundle.
m

 Where is the
slope   most preferred
1 state-contingent
consumption plan?
mL m  L Ca

 State-Contingent Budget
Constraints
Cna
More preferred
m

Where is the
most preferred
state-contingent
consumption plan?
mL m  L Ca

 State-Contingent Budget
Constraints
Cna
Most preferred affordable plan
m

mL m  L Ca

 State-Contingent Budget
Constraints
Cna
Most preferred affordable plan
m

mL m  L Ca

 State-Contingent Budget
Constraints
Cna
Most preferred affordable plan
m MRS = slope of budget
constraint

mL m  L Ca

 State-Contingent Budget
Constraints
Cna
Most preferred affordable plan
m MRS = slope of budget
constraint; i.e.
  a MU(ca )

1    na MU(cna )

mL m  L Ca

 Competitive Insurance
 Suppose entry to the insurance
industry is free.
 Expected economic profit = 0.
 I.e. K - aK - (1 - a)0 = ( - a)K = 0.
 I.e. free entry   = a.
 If price of $1 insurance = accident
probability, then insurance is fair.
 Competitive Insurance
 When insurance is fair, rational
insurance choices satisfy
 a  a MU(ca )
 
1   1   a  na MU(cna )
 I.e. MU(ca )  MU(cna )
 Marginal utility of income must be
the same in both states.
 Competitive Insurance
 How much fair insurance does a risk-
averse consumer buy?
MU(ca )  MU(cna )
 Risk-aversion  MU(c)  as c .
 Hence ca  cna .
 I.e. full-insurance.
 “Unfair” Insurance
 Suppose insurers make positive
expected economic profit.
 I.e. K - aK - (1 - a)0 = ( - a)K > 0.
 Then   > a   a
 .
1 1a
 “Unfair” Insurance
 Rational choice requires
  a MU(ca )

1    na MU(cna )
 Since  a
 , MU(ca ) > MU(cna )
1 1a
 Hence c a < c na for a risk-averter.
 I.e.
a risk-averter buys less than full
“unfair” insurance.
 Uncertainty is Pervasive
 What are rational responses to
uncertainty?
 – buying insurance (health, life, auto)
? – a portfolio of contingent
consumption goods.
 Diversification
 Two firms, A and B. Shares cost $10.
 With prob. 1/2 A’s profit is $100 and
B’s profit is $20.
 With prob. 1/2 A’s profit is $20 and
B’s profit is $100.
 You have $100 to invest. How?
 Diversification
 Buy only firm A’s stock?
 $100/10 = 10 shares.
 You earn $1000 with prob. 1/2 and
$200 with prob. 1/2.
 Expected earning: $500 + $100 = $600
 Diversification
 Buy only firm B’s stock?
 $100/10 = 10 shares.
 You earn $1000 with prob. 1/2 and
$200 with prob. 1/2.
 Expected earning: $500 + $100 = $600
 Diversification
 Buy 5 shares in each firm?
 You earn $600 for sure.
 Diversification has maintained
expected earning and lowered risk.
 Typically, diversification lowers
expected earnings in exchange for
lowered risk.
Risk Spreading/Mutual Insurance
 100 risk-neutral persons each
independently risk a $10,000 loss.
 Loss probability = 0.01.
 Initial wealth is $40,000.
 No insurance: expected wealth is

0  99  $40,000  0  01($40,000  $10,000)

 $39,900.
Risk Spreading/Mutual Insurance
 Mutual insurance: Expected loss is
0  01  $10,000  $100.
 Each of the 100 persons pays $1 into
a mutual insurance fund.
 Mutual insurance: expected wealth is
$40,000  $1  $39,999  $39,900.
 Risk-spreading benefits everyone.
2. Market Demand
 From Individual to Market
Demand Functions
 Think of an economy containing n
consumers, denoted by i = 1, … ,n.
 Consumer i’s ordinary demand
function for commodity j is
x*j i ( p1 , p 2 , mi )
 From Individual to Market
Demand Functions
 When all consumers are price-takers,
the market demand function for
commodity j is
n *i
X j ( p1 , p 2 , m ,, m )   x j (p1 , p 2 , mi ).
1 n
i 1
 If all consumers are identical then
X j ( p1 , p 2 , M )  n  x*j ( p1 , p 2 , m)

where M = nm.
 From Individual to Market
Demand Functions
 The market demand curve is the
“horizontal sum” of the individual
consumers’ demand curves.
 E.g. suppose there are only two
consumers; i = A,B.
 From Individual to Market
p1
Demandp
Functions
1

p1’ p1’
p1” p1”

p1 20 x*A 15 x*1B
1

p1’ The “horizontal sum”

p1” of the demand curves
of individuals A and B.
35
x*1A  xB
1
 Elasticities
 Elasticitymeasures the “sensitivity”
of one variable with respect to
another.
 The elasticity of variable X with
respect to variable Y is
% x
 x ,y  .
% y
 Economic Applications of
Elasticity
 Economists use elasticities to
measure the sensitivity of
– quantity demanded of commodity i
with respect to the price of
commodity i (own-price elasticity
of demand)
– demand for commodity i with
respect to the price of commodity j
(cross-price elasticity of demand).
 Economic Applications of
Elasticity
– demand for commodity i with
respect to income (income
elasticity of demand)
– quantity supplied of commodity i
with respect to the price of
commodity i (own-price elasticity
of supply)
 Economic Applications of
Elasticity
– quantity supplied of commodity i
with respect to the wage rate
(elasticity of supply with respect to
the price of labor)
– and many, many others.
3. Equilibrium
 Market Equilibrium
A market is in equilibrium when total
quantity demanded by buyers equals
total quantity supplied by sellers.
 Market Equilibrium
Market Market
p
demand supply
q=S(p)
D(p*) = S(p*); the market
is in equilibrium.
p*
q=D(p)

q* D(p), S(p)
 Market Equilibrium
Market Market
p
demand supply
q=S(p)
D(p’) < S(p’); an excess
p’ of quantity supplied over
p* quantity demanded.
q=D(p)

D(p’) S(p’) D(p), S(p)

 Market Equilibrium
Market Market
p
demand supply
q=S(p)
D(p’) < S(p’); an excess
p’ of quantity supplied over
p* quantity demanded.
q=D(p)

D(p’) S(p’) D(p), S(p)

Market price must fall towards p*.
 Market Equilibrium
Market Market
p
demand supply
q=S(p)
D(p”) > S(p”); an excess
of quantity demanded
p* over quantity supplied.
p” q=D(p)

S(p”) D(p”) D(p), S(p)

 Market Equilibrium
Market Market
p
demand supply
q=S(p)
D(p”) > S(p”); an excess
of quantity demanded
p* over quantity supplied.
p” q=D(p)

S(p”) D(p”) D(p), S(p)

Market price must rise towards p*.
 Market Equilibrium
 Anexample of calculating a market
equilibrium when the market demand
and supply curves are linear.
D( p )  a  bp
S( p )  c  dp
 Market Equilibrium
Market Market
p
demand supply
S(p) = c+dp
What are the values
of p* and q*?
p*

D(p) = a-bp

q* D(p), S(p)
 Market Equilibrium
D( p )  a  bp
S( p )  c  dp

At the equilibrium price p*, D(p*) = S(p*).

That is, * *
a  bp  c  dp
which gives * ac
p 
bd
* * ad  bc
*
and q  D(p )  S(p )  .
bd
 Market Equilibrium
Market Market
p
demand supply
S(p) = c+dp
*
p 
ac
bd
D(p) = a-bp

* ad  bc D(p), S(p)
q 
bd
 Market Equilibrium
 Can we calculate the market
equilibrium using the inverse market
demand and supply curves?
 Yes, it is the same calculation.
 Market Equilibrium
aq 1
q  D(p )  a  bp  p   D ( q),
b
the equation of the inverse market
demand curve. And

cq
q  S(p )  c  dp  p   S 1 ( q),
d
the equation of the inverse market
supply curve.
 Market Equilibrium
D-1(q), Market
S-1(q) demand Market inverse supply
S-1(q) = (-c+q)/d
At equilibrium,
p* D-1(q*) = S-1(q*).

D-1(q) = (a-q)/b

q* q
 Market Equilibrium
1 aq 1 cq
pD ( q)  and pS ( q)  .
b d
At the equilibrium quantity q*, D-1(p*) = S-1(p*).
That is, * *
aq cq

b d
* ad  bc
which gives q 
bd
* 1 * 1 * ac
and p D (q )  S (q )  .
bd
 Market Equilibrium
D-1(q), Market Market
S-1(q) demand supply
S-1(q) = (-c+q)/d
*
p 
ac
bd
D-1(q) = (a-q)/b

* ad  bc q
q 
bd
 Market Equilibrium
 Two special cases:
– quantity supplied is fixed,
independent of the market price,
and
– quantity supplied is extremely
sensitive to the market price.
 Market Equilibrium
Market Market quantity supplied is
p
demand fixed, independent of price.
S(p) = c+dp, so d=0
and S(p)  c.

p*

D-1(q) = (a-q)/b

q* = c q
 Market Equilibrium
Market Market quantity supplied is
p
demand fixed, independent of price.
S(p) = c+dp, so d=0
and S(p)  c.
p* = p* = D-1(q*); that is,
(a-c)/b p* = (a-c)/b.
D-1(q) = (a-q)/b

* a  c q* = c q
* ac
p  p 
bd b
with d = 0 give
* ad  bc
q  q*  c.
bd
 Market Equilibrium
 Two special cases are
– when quantity supplied is fixed,
 independent of the market price,
and
– when quantity supplied is
extremely sensitive to the market
price.
 Market Equilibrium
Market Market quantity supplied is
p
demand extremely sensitive to price.
S-1(q) = p*.
p* = D-1(q*) = (a-q*)/b so
p* q* = a-bp*

D-1(q) = (a-q)/b

q* = q
a-bp*
 Quantity Taxes
A quantity tax levied at a rate of $t is
a tax of $t paid on each unit traded.
 If the tax is levied on sellers then it is
an excise tax.
 If the tax is levied on buyers then it is
a sales tax.
 Quantity Taxes
 What is the effect of a quantity tax on
a market’s equilibrium?
 How are prices affected?
 How is the quantity traded affected?
 Who pays the tax?
 How are gains-to-trade altered?
 Quantity Taxes
A tax rate t makes the price paid by
buyers, pb, higher by t from the price
received by sellers, ps.

pb  ps  t
 Quantity Taxes
 Even with a tax the market must
clear.
 I.e. quantity demanded by buyers at
price pb must equal quantity supplied
by sellers at price ps.

D( pb )  S( ps )
 Quantity Taxes
pb  ps  t and D( pb )  S( ps )
describe the market’s equilibrium.
Notice that these two conditions apply no
matter if the tax is levied on sellers or on
buyers.

Hence, a sales tax rate $t has the

same effect as an excise tax rate $t.
Quantity Taxes & Market Equilibrium
Market Market
p
demand supply
An excise tax
raises the market
pb $t supply curve by $t,
p* raises the buyers’
ps
price and lowers the
quantity traded.
qt q* D(p), S(p)
And sellers receive only ps = pb - t.
Quantity Taxes & Market Equilibrium
Market Market
p
demand supply
An sales tax lowers
the market demand
pb curve by $t, lowers
p* the sellers’ price and
ps
reduces the quantity
$t traded.
qt q* D(p), S(p)
And buyers pay pb = ps + t.
Quantity Taxes & Market Equilibrium
Market Market
p
demand supply
A sales tax levied at
rate $t has the same
pb $t effects on the
p* market’s equilibrium
ps
as does an excise tax
$t levied at rate $t.
qt q* D(p), S(p)
 Quantity Taxes & Market
Equilibrium
 Who pays the tax of $t per unit
traded?
 The division of the $t between buyers
and sellers is the incidence of the
tax.
Quantity Taxes & Market Equilibrium
Market Market
p
demand supply
Tax paid by
pb buyers
p*
ps Tax paid by
sellers

qt q* D(p), S(p)
 Quantity Taxes & Market
Equilibrium
 E.g.
suppose the market demand and
supply curves are linear.
D( pb )  a  bpb
S( ps )  c  dps
 Quantity Taxes & Market
Equilibrium
D(pb )  a  bpb and S( ps )  c  dps .
With the tax, the market equilibrium satisfies

pb  ps  t and D( pb )  S( ps ) so
pb  ps  t and a  bpb  c  dps .

Substituting for pb gives

a  c  bt
a  b( ps  t )  c  dps  ps  .
bd
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps  and pb  ps  t give
bd
a  c  dt
pb 
bd
The quantity traded at equilibrium is

qt  D( pb )  S( ps )
ad  bc  bdt
 a  bpb  .
bd
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps 
bd t ad  bc  bdt
q 
a  c  dt bd
pb 
bd
As t  0, ps and pb  a the
c
 p *,
equilibrium price if bd
there is no tax (t = 0) and qt ad  bc
the quantity traded at equilibrium  ,
when there is no tax.
b d
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps 
bd t ad  bc  bdt
q 
a  c  dt bd
pb 
bd
As t increases, ps falls,
pb rises,
and qt falls.
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps 
bd t ad  bc  bdt
q 
a  c  dt bd
pb 
bd
The tax paid per unit by the buyer is
a  c  dt a  c
* dt
pb  p    .
bd bd bd
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps 
bd t ad  bc  bdt
q 
a  c  dt bd
pb 
bd
The tax paid per unit by the buyer is
*a  c  dt a  c dt
pb  p    .
bd bd bd
The tax paid per unit by the seller is
* a  c a  c  bt bt
p  ps    .
bd bd bd
 Quantity Taxes & Market
Equilibrium
a  c  bt
ps 
bd t ad  bc  bdt
q 
a  c  dt bd
pb 
bd
The total tax paid (by buyers and sellers
combined) is

t ad  bc  bdt
T  tq  t .
bd
 Tax Incidence and Own-Price
Elasticities
 Theincidence of a quantity tax
depends upon the own-price
elasticities of demand and supply.
Tax Incidence and Own-Price Elasticities
Market Market
p
demand supply
Change to buyers’
pb $t price is pb - p*.
Change to quantity
p*
demanded is q.
ps

qt q* D(p), S(p)

q
 Tax Incidence and Own-Price
Elasticities
Around p = p* the own-price elasticity
of demand is approximately

q
q * q  p*
D   pb  p*  .
pb  p*  D  q*
p*
Tax Incidence and Own-Price Elasticities
Market Market
p
demand supply
Change to sellers’
pb $t price is ps - p*.
Change to quantity
p*
demanded is q.
ps

qt q* D(p), S(p)

q
 Tax Incidence and Own-Price
Elasticities
Around p = p* the own-price elasticity
of supply is approximately

q
q * q  p*
S   ps  p*  .
ps  p*  S  q*
p*
Tax Incidence and Own-Price Elasticities
Market Market
p
demand supply
Tax paid by
pb buyers
p*
ps Tax paid by
sellers

qt q* D(p), S(p)
Tax Incidence and Own-Price Elasticities
Market Market
p
demand supply
Tax paid by
pb buyers
p*
ps Tax paid by
sellers

qt q* D(p), S(p)
*
pb  p
Tax incidence = .
*
p  ps
 Tax Incidence and Own-Price
Elasticities
*
pb  p
Tax incidence = .
*
p  ps
* *
* q  p * q  p
pb  p  . ps  p  .
* *
D  q  S q
*
So pb  p S
  .
*
p  ps D
 Tax Incidence and Own-Price
Elasticities
*
pb  p S
Tax incidence is   .
*
p  ps D

The fraction of a $t quantity tax paid

by buyers rises as supply becomes more
own-price elastic or as demand becomes
less own-price elastic.
 Tax Incidence and Own-Price
Elasticities
Market Market
p
demand supply
As market demand
pb $t becomes less own-
p* price elastic, tax
ps incidence shifts more
to the buyers.

qt q* D(p), S(p)
 Tax Incidence and Own-Price
Elasticities
Market Market
p
demand supply
As market demand
pb $t becomes less own-
ps= p*
price elastic, tax
incidence shifts more
to the buyers.

qt = q* D(p), S(p)
 Tax Incidence and Own-Price
Elasticities
Market Market
p
demand supply
As market demand
pb $t becomes less own-
ps= p*
price elastic, tax
incidence shifts more
to the buyers.

qt = q* D(p), S(p)
When D = 0, buyers pay the entire tax, even though it is
levied on the sellers.
 Tax Incidence and Own-Price
Elasticities
*
pb  p S
Tax incidence is   .
*
p  ps D

Similarly, the fraction of a $t quantity

tax paid by sellers rises as supply
becomes less own-price elastic or as
demand becomes more own-price elastic.
Deadweight Loss and Own-Price
Elasticities
A quantity tax imposed on a
competitive market reduces the
quantity traded and so reduces
gains-to-trade (i.e. the sum of
Consumers’ and Producers’
Surpluses).
 The lost total surplus is the tax’s
deadweight loss, or excess burden.
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply

No tax
CS
p*
PS

q* D(p), S(p)
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply
The tax reduces
pb CS $t both CS and PS
p*
ps PS

qt q* D(p), S(p)
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply
The tax reduces
pb CS $t both CS and PS,
transfers surplus
p* Tax
to government
ps PS

qt q* D(p), S(p)
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply
The tax reduces
pb CS $t both CS and PS,
transfers surplus
p* Tax
to government,
ps PS
and lowers total
surplus.

qt q* D(p), S(p)
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply

pb CS $t
p* Tax
ps PS
Deadweight loss

qt q* D(p), S(p)
Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply
Deadweight loss falls
pb $t as market demand
p* becomes less own-
ps price elastic.

qt q* D(p), S(p)
 Deadweight Loss and Own-Price
Elasticities
Market Market
p
demand supply
Deadweight loss falls
pb $t as market demand
ps= p* becomes less own-
price elastic.

qt = q* D(p), S(p)
When D = 0, the tax causes no deadweight loss.
Deadweight Loss and Own-Price
Elasticities
 Deadweight loss due to a quantity
tax rises as either market demand or
market supply becomes more own-
price elastic.
 If either D = 0 or S = 0 then the
deadweight loss is zero.