Consumer Theory at

Work

Objective
From Consumers to Demand
Coupons and cash subsidies; Joining a club
Mobile phone plans;
Network Externalities
Labour Supply
ECONOMIC ANALYSIS 1
BB 1.2; 2.1; 2.2; 5.1; 5.2; 5.4; 5.5; 4.3
Outline:
How can we use the model of Consumer
Theory to understand choices?
Network Externalities?
Income subsidies or vouchers?
Why would one get a membership for a club?
Which mobile phone plan?
Labour Supply?
What is next?
ECONOMIC ANALYSIS 2
BB 4.1; 4.2

We know from the previous lecture that a

Rational, self-interested consumers chooses:

Point E, the point

of tangency
between the BC
and an IC

At E is
maximizing Utility
subject to a BC
ECONOMIC ANALYSIS 3
 How can we use this model to
BB: 1.2; 5.1; 5.2

understand choices?
l Things that are exogenous to the consumer:
Income (M), prices (pA and pB)
l What happens if these change?

COMPARATIVE STATICS
(ceteris paribus thought experiment)

ECONOMIC ANALYSIS 4
What if Income changes (and prices do
not)?

Engel’s Demand curves= Qt. of a good as a function of the

Income that is available to the consumer.
ECONOMIC ANALYSIS 5
 What if the price of a good changes (and
income and prices of other goods do
not)?
The total change in
demand that follows a
change in the price of a
good is made of:
•Substitution Effect: since
the good becomes more
(vs. less) expensive, this
good becomes less (vs.
more) attractive relative to
other goods
and ECONOMIC ANALYSIS 6
What if the price of a good changes (and
income and prices of other goods do
not)?
•Income Effect: although
nominal income does not
change, its purchasing
power does. If a good
becomes more (vs. less)
expensive, real income
decreases (vs. increases).
This change in real income
may lead to a further
change in demand.

ECONOMIC ANALYSIS 7
 What if the price of a good changes (and
income and prices of other goods do
not)?
Price of chocolate bar
increases.
Move from E0 to E1 can
be decomposed into:
move from E0 to E2
(Substitution Effect)
and
move from E2 to E1
(Income Effect)
ECONOMIC ANALYSIS 8
•Income and Substitution effects with a quasi-
linear utility function:
•Learning-by-Doing Exercise 5.6
•You can download the excel file ch05.xls

ECONOMIC ANALYSIS 9
BB: 2.1

•Once we know the demand curve for each

consumer we can aggregate demands and get
the market demand curve

Recall: you need to aggregate Quantities (not Prices)

Hence: 1) express demands as Q=f(P)
ECONOMIC ANALYSIS 10

2) aggregate them
 From consumers to markets:

l What determines the price level in a market?

l How do prices change in response to shocks?

l How is demand/supply logic used to forecast

price evolution in markets?

ECONOMIC ANALYSIS 11
Supply curve (next topic, but..)
l Quantity provided at any given price,
holding everything else constant
l Typically upward sloping
l Position and shape depend on:
l Input prices Supply curve
l Technology used Price
l Number of suppliers
11
l Expectations (speculation)
10

ECONOMIC ANALYSIS
Units
12
4 5
 Demand curve
l Quantity demanded at any given price,
holding everything else constant
l Typically downward sloping
l Position and shape depend on:
l Prices of substitute and
complement products Price
l Buyers’ preferences 11
l Buyers’ income
l 10
Expectations (speculation)

ECONOMIC ANALYSIS 4 5 Units

13
Market equilibrium
P
Excess Supply
S

! Law of Supply and Demand

*Excess supply => Price falls
*Excess demand => Price rises Excess Demand D

l In free markets prices and quantities tend

towards the equilibrium.
l Why?
l Is this model descriptive?
ECONOMIC ANALYSIS 14
Supply curve shifts
l Supply curve shifts due to changes in
l Input prices
l Technology
l Number of suppliers
l Expectations Price

Units
q q’
ECONOMIC ANALYSIS 15
 Price and quantity effects of
shift

Supply Supply
(high wages) (high wages)
Supply
Supply (low wages)
(low wages)

Price insensitive (inelastic) demand Price sensitive (elastic) demand

ECONOMIC ANALYSIS 16
Example: Housing Market in the UK

ECONOMIC ANALYSIS 17
BB: 4.3

3. Coupons and Subsidies:

l How can a
government
program
increase the
amount of
housing (or
food or
education)
chosen by a
consumer?
ECONOMIC ANALYSIS 18
Besanko & Braeutigam/Microeconomics: An Integrated Approach
Chapter 4, Figure 04-10
 •Subsidy ($S to
spend):
BC moves from IJ to
EG
•Voucher ($S for
housing):
BC moves from IJ to
KFG

This consumer is
indifferent btw a
subsidy and a
voucher and will
Besanko & Braeutigam/Microeconomics: An Integrated Approach
Chapter 4, Figure 04-11 ECONOMIC ANALYSIS choose B. 19
 •Subsidy ($S to
spend):
BC moves from IJ to
MN. Choose T.
•Voucher ($V for
housing):
BC moves from IJ to
KRG

This consumer
prefers the subsidy.
Gov. can induce hb
Besanko & Braeutigam/Microeconomics: An Integrated Approach
Chapter 4, Figure 04-12
with a voucher
(subsidy costs $S-$V
ECONOMIC ANALYSIS
more!) 20
4. Joining a club.
Buy a membership at £100
and buy CDs for $10 instead of $20.

•If you do not join:

you face BL1, buy 10
CDs, enjoy utility U1
•If you join:
you face BL2, you
buy 15 CDs, enjoy
utility U2>U1 !

ECONOMIC ANALYSIS 21
5. Which mobile phone plan.

•Plan B: pay $300, get

1000 min for free, pay
$0.25 pm beyond: NSV
•Plan A: pay £350, get
400 min for free, pay
$0.35 pm beyond: MRT
•This consumer is better
off under plan B (Others
may not…)

ECONOMIC ANALYSIS 22
BB: 5.4
6. Network externalities.

l If one consumer's demand for a good changes

with the number of other consumers who buy
the good, there are network externalities.

ECONOMIC ANALYSIS 23
l Bandwagon effect: A positive network
externality that refers to the increase in each
consumer’s demand for a good as more
consumers buy the good

ECONOMIC ANALYSIS 24
 PX D60

D30 Bandwagon Effect:

• (increased quantity
demanded when more
A consumers purchase)
20
•
B C
10 • •
Pure Market Demand
Price
Effect
Bandwagon
Effect

60
ECONOMIC ANALYSIS 25
l Snob effect: A negative network externality that
refers to the decrease in each consumer’s
demand as more consumers buy the good

ECONOMIC ANALYSIS 26
PX

Market Demand Snob Effect:

• (decreased quantity
demanded when more
A consumers purchase)
•
C B
900 • • D1000

D1300
Snob Effect

Pure Price Effect

ECONOMIC ANALYSIS
X (units)27
BB: 5.5
7. Labout-Leisure tradeoff

l Divide the day into two parts: Work hours and

leisure (non work) hours.
l Earns income during work hours and uses the
income to pay for activities he enjoys in his
leisure time.

ECONOMIC ANALYSIS 28
Defining Labor Supply

l Total Daily income:

l w(24-L)

where w is the hourly wage rate

L is the leisure hours
24 is the 24 hours in a day

ECONOMIC ANALYSIS 29
Supply of Labor

l An increase in wage rate reduces the amount of

labor required to buy a unit of the composite
good
l This leads to both a Substitution effect and
Income effect.

ECONOMIC ANALYSIS 30
Labor Supply Curve

l The labor supply curve slopes upward over the

region where the substitution effect associated
with the wage increase outweighs the income
effect, but bends backward over the region
where the income effect outweighs the
substitution effect.

ECONOMIC ANALYSIS 31
Labor Supply Curve

ECONOMIC ANALYSIS 32
 Summary
Supply, demand, and equilibrium
l movements along a curve (change in own
price)
l shifts of a curve (change in other factors)

Predict price evolution with

l current imbalance of production and
consumption (short run)
l projection of demand and supply (long run)

ECONOMIC ANALYSIS 33
 Consumer Objective
Theory at From Consumers to Demand
work Coupons and cash subsidies; Joining a club;
Mobile phone plans;
Network externalities;
Labour Supply

What is next?
How about intertemporal choices?
What if we face uncertainty?

ECONOMIC ANALYSIS 34