II. CONSUMER DEMAND

    Goal: to investigate more closely what makes consumers tick
    --what influences their decisions
    --what policies we might use and the effects of those policies

    We will now switch from what we call partial equilibrium to general equilibrium analysis

    Partial equilibrium analysis: studies individual markets in isolation
        Uses S&D diagrams

    General equilibrium analysis: studies how markets are linked together
        Uses diagrams which look at more than 1 item at a time

    We'll introduce new tools for analyzing consumer behavior:
        budget lines and indifference curves.

    A. THE RATIONAL CONSUMER

--Basic setup

    Consumption set: set of all possible consumption bundles.

    3 key ingredients of consumer theory:
    (1) Utility--total satisfaction

    Total utility = total consumer satisfaction or "psychic glow"
    Formerly thought to be measurable--"utils" (cardinal utility).
    This made interpersonal comparisons possible
    Today's theory: only utility ranking for an individual is possible, not quantitative measuring.

    Ordinal utility: allows people to rank their consumption bundles

    Ordinal utility: "Are you better off now than you were 4 years ago?"
    Interpersonal comparisons aren't possible

    Utility function: U = U(x,y,z,...)

    Ex: U = U(Rum,Coke)

    (2) Budget constraint

    Constraints:
    Prices
    Income

    (3) Goal: consumers try to maximize utility
   --given their budget constraint

    We'll consider the constraint consumers face first, then their utility, and then how the two get combined in uitlity maximization

    1. CONSUMER CONSTRAINTS AND THE BUDGET LINE (BL)

    BL reflects the consumer's price and income constraints
    (handout: The budget line and its slope)

    Consider a 2-good world as usual
    Constraint on consumer's spending:

    I = Px· X + Py·Y

    (1) the geometry of the BL

    It would be nice to incorporte this constraint into the diagram we've set up to illustrate alternative consumption bundles.
    To do this, we need to rearrange terms to express the amount of Y you can buy as a function of how much X you buy:

    Rearrange terms:

             I           Px
    Y = -----  -  ------ ·X
            Py         Py

    BL is a straight line:
    I/Py = intercept
    Px/Py = slope

    All the points outside the BL are unattainable unless income rises or prices fall.
    BL = a "consumption possibilities frontier."

    Intercept term: I/Py
    ? What does the value of the intercept tell you?

    Slope term: Px/Py
    ? What economic information is reflected in the slope of the BL?

    (2) the mathematics of the BL slope

    DTE = PxDX + PyDY

    Along a BL, DTE = 0 which =>

    PyDY = -Px DX =>

        |-DY/DX| = Px/Py.
    The size of the slope of a BL = the price of X relative to Y.

    (3) the logic of the BL slope

    Budget line examples:
    worksheet
    spreadsheet (Excel)
    illustrations of worksheet examples (Java)

    Recap: the types of BL variations that can occur:
    (1) Parallel shifts: When income changes, we get this
    (2) Rotations: when relative prices change, we get this.
        Example: Up Px => steeper BL ((1) higher opp.cost (2) can't afford as much X)
    (3) Kinks: when relative prices vary along a BL.

    A useful specification of the budget line:
    X = a product of interest
    Y = Ig = $ of income spent on all goods other than X 

    Graph point A at X=4

    ? How much income are you spending on goods OTHER than X?

    ? And how much income are you spending on X (TEx)

   You can read TEx directly from the vertical axis:
    Whatever income isn't spent on other goods is spent on X

    TEx = I - Ig

    In other words, how far you've moved down your BL to reach your consumption of good X tells you how much income you've used up to buy it, and that's your total expenditure on X (TEx).

    Real world applications (Java)

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