Agenda: Consumer Equilibrium Change in Equilibrium Income and Substitution Effects Demand Tastes and Preferences Affects on Demand

emand Consumer Surplus

Consumer Equilibrium: Consumer equilibrium is comprised of two concepts: The utility function The budget constraint Consumer equilibrium can be defined as a consumption bundle that is feasible given a particular budget constraint and maximizes total utility. In graphical terms, consumer equilibrium is defined as the point where the highest utility function touches the budget constraint Consumer Equilibrium Example: Suppose we have the following utility function: U = u(x1,x2) = x1 * x2 Where x1 is equal to the number of hotdogs consumed Where x2 is equal to the number of sodas consumed Suppose we have the following budget constraint: I = p1*x1 + p2*x2 Where pi is equal to the price of hotdogs consumed Where pj is equal to the price of sodas consumed

 Now consider that you have a price of hotdogs equal to $2 and a price of soda is a $1. Also suppose that our income is $10. Examine the different indifference curves of U = 1, U=12.5, and U = 25

Consumption of sodas

Consumption of hotdogs

Intuitively what we have done in the graph is equate the tradeoff from prices to the tradeoff in utility. I.e., (p2/p1) = (MU2/MU1) Where p2 is the price of good 2 and p1 is the price of good 1 Where MU2 is the marginal utility of consuming good 2 and MU1 is the marginal utility of consuming good 1

(p2/p1) = (MU2/MU1) can be rewritten as: (MU2 / p2) = (MU1 / p1) This says that you are normalizing the change in utility by the price of the good and then equating it to the normalized marginal utility of the other good. Another way to look at this is to say that the marginal utility derived from the last dollar spent for each good is equal. What happens if one side is greater than the other?

Changes in Equilibrium: There are many things that can change consumer equilibrium. The major two items that we will examine that can change consumer equilibrium, ceteris paribus:

 Income Price of each good Note: Ceteris paribus means that we hold everything else fixed. Mathematical Side Note on Ceteris Paribus: There are many things that enter our utility function which we can represent with the following utility function: U = u(x1, x2, x3, , xn) When we say that we want to examine utility with respect to x1 and x2, ceteris paribus, what we are saying is that we hold constant the values for all other goods. Mathematically, we can represent holding things constant in the following two manners: U = u(x1, x2; x3, , xn) or U = u(x1, x2| x3, , xn) Where it is understood using this notation that goods x3 through xn are held at some constant level. Change in Equilibrium Example:

Suppose Dr. Hurley is consuming a basket of goods that only has two items, chips and soda. Assume for the moment that the price is held constant for chips at $1.00 and the price for soda is held constant at $1.00. Also assume that Dr. Hurley has $10 for this basket of goods and his utility function is represented by U = u(soda, chips) = soda * chips. What is Dr. Hurleys initial consumer equilibrium? Mathematically we can represent Dr. Hurleys problem as the following: Dr. Hurleys utility function: U = u(x1, x2) = x1 * x2 Dr. Hurleys budget constraint:

 M = p1*x1 + p2*x2 10 = 1*x1 + 1*x2 Where x1 is the quantity of soda consumed Where x2 is the quantity of chips consumed

Graphically Finding the Maximum Utility:

To find the maximum utility we can make the following argument: We know that are maximum utility point must lie on the budget line assuming all the consumption goods are desirable and we are nonsatiated, i.e.,utility is always increasing. This being the case we can examine the points on the budget line to see which provides the highest utility. Once we have found the maximum utility on the budget curve, we can hold our utility fixed and draw the utility function.

max Change in Equilibrium Example Cont:

Observations on Changing Equilibrium:

Coincidently, the consumption of chips did not change. This is a property of the function we used, it is not always true. The line/curve that connected all three equilibrium points is considered a price consumption curve.

 This curve relates the quantity of chips and soda consumed when changing the price of soda. As price went down for soda, more was consumed and when price went up for soda less was consumed. There are two effects at work when price changes: The income effect The substitution effect Income and Substitution Effects: Substitution Effect It is the change in the quantity consumed due to a change in the price of the good, while holding other prices for goods constant and utility constant. Income Effect It is the change in the quantity consumed due to a relative increase in a change of income while holding prices constant

Graphical Example: Assume that the price for soda has decreased. To find the substitution effect graphically, we examine what quantities would be consumed if the consumer had to stay on her original indifference curve facing the new prices. This is equivalent to taking a parallel line to the new budget line and setting it tangent, i.e., just touching at one point, to the old utility level.