Perloff Reference Chapters:

Chapter 4: pp. 92-105,

Chapter 5: pp. 112-128

1
Consumer Equilibrium
Change in Equilibrium
Income and Substitution Effects
Demand
Tastes and Preferences Affects on Demand
Consumer Surplus

2
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.

3
If there was no budget constraint, a person
would consume each good to the point
where marginal utility of consumption for
each good is zero.
 Why?
Given a budget constraint, the consumer
maximizes total utility by consuming a
bundle that is feasible.
 A feasible bundle is one that lies either on or
inside the budget constraint.

4
In graphical terms, consumer equilibrium is
defined as the point where the highest utility
function touches the budget constraint.

5
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

6
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

7
 x2
Consumption of sodas

10

U = 25
5
U = 12.5

1
U=1
1 2.5 5 x1
Consumption of hotdogs 8
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

9
(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?

10
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.

11
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.

12
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.

13
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.

14
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. Hurley’s initial consumer
equilibrium?

15
Mathematically we can represent Dr. Hurley’s
problem as the following:
 Dr. Hurley’s utility function:
U = u(x1, x2) = x1 * x2
 Dr. Hurley’s 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

16
Consumption of Chips

10

5
U = 25

1 5 10
Consumption of soda 17
How did Dr. Hurley know that consuming 5
chips and 5 sodas will maximize utility?
 He used advance math that you will learn in Ag
Bus 313?
 But there is another way you can find the
answer.

18
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
non-satiated, 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.

19
 10 = x1 + x2, U = u(x1,x2) = x1 * x2
Consumption of x1 Consumption of x2 Total Utility from consumption

0 10 0 = 0 * 10
1 9 9=9*1
2 8 16 = 2 * 8
3 7 21 = 3 * 7
4 6 24 = 4 * 6
5 5 25 = 5 * 5 Maximum

6 4 24 = 6 * 4
7 3 21 = 7 * 3
8 2 16 = 8 * 2
20
What happens if we change the price of soda
from $1 to $2 holding the price of the chips
constant.
What happens if we change the price of soda
from $1 to $0.50 holding the price of the chips
constant.

21
Consumption of Chips

10

5 U = 50
U = 12.5 U = 25

2.5 5 10 20 22
Consumption of soda
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.

23
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

24
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.

25
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.

26
 Quantity of Chips Original consumption level

Original
Budget line New consumption level

I2

I1

New Budget Quantity of Soda

Substitution Line
Income
Effect Effect
27
The total effect of a price change is the
summation of the substitution and income
effect.
The substitution and income effect can
work in opposite direction of each other.
The income effect defines whether the
good is an inferior good or a normal good.

28
A normal good can be defined as a good
whose consumption has a positive correlation
with the income effect.
An inferior good can be defined as a good
whose consumption has a negative correlation
with the income effect.

29
 Price of Soda Quantity Demanded
 By changing the price of Soda
of soda and examining
the new equilibrium $0.50 10
point, we can derive the $1.00 5
demand curve for soda $2.00 2.5
for an individual.
 Summarizing the
changing equilibrium
example gives the
following demand
schedule for soda:

30
Price of
Soda
$2.00 •

$1.00 •
$0.50 •

2.5 5 10

Quantity of Soda
31
Now suppose we P Demand curve
change the price for soda
for soda on a
continuous basis.
 Instead of points
on the graph, you
would begin to see
a curve like the
following: Q

32
We have seen that using the idea of a budget
constraint and utility function, we can derive a
person’s demand schedule or curve.
 A demand schedule is a table that shows the
relationship between the quantity demanded of
a good and its corresponding price.

33
When we derived demand, we only change
the price of the good we were investigating
and the change in the quantity demanded for
the good.
 Prices of the other good(s) and income were
held fixed.
 Any other variable that might affect the utility
function were held fixed also.

34
We can mathematically represent demand
for good i as the following:
 D(pi) = d(price of good i| price of all other goods
and income)
 D(pi) = d(pi| p1, p2, …, pi-1, pi+1, …, pn, M)
 Where d(·) is a functional relationship that maps prices
to quantities.
 pi is the price of good i
 pj for j = 1,2, …, i-1, i+1, …, n are the prices of all
other good except good i
 M is the persons income.

35
Beside the price of the good, there are three
other major items that affect the demand
curve:
 Income (M)
 Prices of other goods (pj)
 Tastes and preferences
This can either show up as a variable in the demand
function or it can change the function altogether.

36
Remember that an increase in income shifts
the budget curve out, while a decrease in
income shifts the budget curve in.
Does an increase in income imply that you will
always increase demand for a good?
 No. It depends on whether the good is a
inferior or normal good.

37
A good can be classified as a normal good if
the consumption for it has a positive
correlation with income.
 I.e., when income increases, you consume more
of the good and when income decreases you
consume less.

38
A good can be classified as an inferior good if
the consumption for it has a negative
correlation with income.
 I.e., when income increases, you consume less
of the good and when income decreases you
consume more.

39
A good can be both a normal good and an
inferior good.
 It all depends on where you are on the level of
consumption of the good and your income.
 Suppose you have $10 to use for buying food each
week. You might try living off spaghetti because you
cannot afford steak.
 What happens when your income doubles, you might
find yourself eating more spaghetti and still no steak.
 What happens if you have $100 to spend, you might
begin to eat less spaghetti and start consuming steak.

40
Engel’s curve tells you what happens to your
consumption of a good as you change your
level of income.

41
The demand curve for a particular good may
shift if the price of another good changes.
How the demand curve shifts will depend on
whether the goods are substitutes,
complements, or have no correlation.

42
Good j is said to be a substitute of good i if an
increase in the price of good j causes you to
consume more of good i.
Good j is also said to be a substitute of good i
if a decrease in the price of good j causes you
to consume less of good i.
 I.e., the demand for product i is positively
correlated with the price of product j.

43
Good j is said to be a complement of good
i if an increase in the price of good j causes
you to consume less of good i.
 Good j is also said to be a complement of
good i if a decrease in the price of good j
causes you to consume more of good i.
 I.e., the demand for product i is negatively
correlated with the price of product j.

44
Composition of the Population
Attitudes toward Nutrition and Health
Food Safety
Lifestyles
Technological Forces
Advertising

45
Consumer surplus is a measure of the
difference between the amount of money a
person was willing to pay to buy a quantity
of good and the actual price they paid.
This measure is used as a tool in policy
analysis.
Consumer surplus is represented
graphically as the area underneath the
demand curve above the price paid for the
goods.
46
 P

Consumer Surplus

p=5

q=5
Q
47