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Consumer Equilibrium: Optimal Choice of Bundle

This document summarizes consumer equilibrium concepts. It explains that consumer equilibrium occurs where the marginal rate of substitution between goods equals the price ratio. It also discusses how changes in prices and income can shift consumer equilibrium through substitution and income effects. Price decreases can lead to either increases or decreases in demand, depending on whether the good is normal or inferior. The document also introduces the rare case of Giffen goods, where the income effect of a price decrease is so large and negative that it outweighs the substitution effect, causing demand to paradoxically increase.

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Tahir Naeem
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© Attribution Non-Commercial (BY-NC)
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Download as PDF, TXT or read online on Scribd

Topics covered

  • Welfare Economics,
  • Budget Constraint,
  • Utility Maximization,
  • Market Dynamics,
  • Income Consumption Curve,
  • Income Shifts,
  • Income Effect,
  • Microeconomic Theory,
  • Behavioral Economics,
  • Graphical Analysis
59 views13 pages

Consumer Equilibrium: Optimal Choice of Bundle

This document summarizes consumer equilibrium concepts. It explains that consumer equilibrium occurs where the marginal rate of substitution between goods equals the price ratio. It also discusses how changes in prices and income can shift consumer equilibrium through substitution and income effects. Price decreases can lead to either increases or decreases in demand, depending on whether the good is normal or inferior. The document also introduces the rare case of Giffen goods, where the income effect of a price decrease is so large and negative that it outweighs the substitution effect, causing demand to paradoxically increase.

Uploaded by

Tahir Naeem
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Topics covered

  • Welfare Economics,
  • Budget Constraint,
  • Utility Maximization,
  • Market Dynamics,
  • Income Consumption Curve,
  • Income Shifts,
  • Income Effect,
  • Microeconomic Theory,
  • Behavioral Economics,
  • Graphical Analysis

Nick Baigent/Intro micro/SS2006

Consumer Equilibrium
Optimal choice of bundle
y

y*

x x*

Utility Maximization subject to a budget constraint Equilibrium bundle: slopes of IC and BC are equal MRS = Px/Py

Nick Baigent/Intro micro/SS2006

In Equilibrium: Slope of BC = slope IC


px MU x = MRS = py MU y

MU x MU y = px py

Alternative/equivalent characterisation of consumer equilibrium.

Nick Baigent/Intro micro/SS2006

MU x MU y Suppose > px py

8 4 > 1 2
1 less y utility falls by 4 2 more euros to spend on x buy 2 more x utility goes up by 16 net increase in utility of 12 If LHS falls and RHS goes up to give an equality, then we have an equilibrium.

Nick Baigent/Intro micro/SS2006

Changes in consumer equilibrium


y

income consumption cuve for normal goods

x y

income consumption cuve for y normal and x inferior

Nick Baigent/Intro micro/SS2006

Engel curve for normal good


m

Engel curve for inferior good


m

Nick Baigent/Intro micro/SS2006

Price consumption curve


y

Price consumption curve

x y

Nick Baigent/Intro micro/SS2006

Compensating change in income

BC2 after price fall

BC1 BC3 after compensation to original IC

Nick Baigent/Intro micro/SS2006

x S
I

substitution effect S (original IC)

income effect I (higher IC)

total change in demand for x from a fall in its price.

Nick Baigent/Intro micro/SS2006

Summary
Subst Effect: relative price change with const utility Substitution Effect must always be negative: More x from lower relative price of x. Income Effect: effect of having more (less) money because of price change. Income effect can be positive or negative: Remember slope of income consumption curve. Therefore, the total effect can be positive or negative. So if price goes down, demand may go up or down!

Nick Baigent/Intro micro/SS2006

Giffen Good
y

Can we explain Giffen goods using income and substitution effects?

10

Nick Baigent/Intro micro/SS2006

S I

For a Giffen good: Income effect must be negative inferior good Income effect must be larger than subst effect For Giffen goods, demand curve slopes up! Price change leads to switching income to higher quality goods

11

Nick Baigent/Intro micro/SS2006

Allocation of time
Work or leisure Work gives more income and more consumption More work more consumption less leisure Less work less consumption more leisure

leisure

consumption Leisure normal good ----- Work inferior good Wage increase --- more consumption Wage increase --- more leisure Wage increase --- less work So work may be an inferior or Giffen good!

12

Nick Baigent/Intro micro/SS2006

Summary and Conclusions


Subst effect must be negative Income effect positive or negative Giffen: Income effect is opposite in sign to and larger than Subst effect Assumptions giving standard indifference curves are not enough to make sure dcurve slopes down.

13

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