Chapter 4.

Consumer Behavior and Individual Demand

4.1. The Utility Function 4.1.1. Characteristics 4.1.2. Depicting the Utility Function: The Cobb-Douglas Illustration 4.2 Indifference Curves 4.3 Budget Constraints and Constrained Maximization 4.3.1. The Budget Constraint 4.3.2. Utility Maximization subject to the Budget Constraint 4.4 Comparative Statics 4.4.1. Money Income Changes 4.4.2. Proportional Absolute Price 4.4.3. Single Price Change 4.4.3.1. Uncompensated 4.4.3.2. Compensated: Separating the Income and Substitution Effects 4.5. The Individuals Demand Curve 4.5.1. Compensated 4.5.2. Uncompensated 4.6. Consumer Surplus 4.7. Chapter Summary 4.8 Looking Ahead Economic models of consumer behavior assume that the consumer makes decisions that enhance his or her well being.1 The consumers choices depend on preferences (referred to in terms of a utility function below) and constraints. This chapter explores a model of the consumers response to changes in money income and prices. It also shows how consumer surplus, introduced in the preceding chapter, is derived from the utility function.

4.1.

The Utility Function Economic analysis of consumer behavior begins with a utility function. This function

defines what determines the consumers level of well-being, however that term may be construed. The analyst typically does not specify a functional form for the utility function, except for

A wag has claimed that economics explores the implications of individuals decisions, and sociology explains why individuals cannot make decisions. Economics does not explore in depth how the consumers preferences are established. As principles textbooks point out, the reason for beginning at the individual level is to avoid committing the Fallacy of Composition. 4 -1

purposes of illustration. (Of course, we must specify a functional form, and a fairly simple one, for our Excel-based illustration.) In general, the utility function may be written as follows: U = f(X1, X2, , XN; S1, S2, , SM). (4.1)

In this equation, U is a measure of utility and Xs and Ss are goods or services (goods hereafter). We may specify two classes of goods, material goods, the X goods, (bread, butter, clothing, entertainment) and spiritual goods, the S goods, (love of ones family, love of ones God, love of ones country). Economics focuses primarily, though not exclusively, on the X goods.

4.1.1

Characteristics of a Utility Function In general, an acceptable utility function must satisfy three conditions: it must be

complete (that is, a utility level must be attached to every combination of goods and services that the consumer can enjoy), it must depict consistent behavior, and it must satisfy a transitivity condition. In addition, we commonly add an assumption that for all goods more is preferred to less.
1.

Completeness. The consumer must be able to compare any possible combination of Xs and Ss, assigning a value of U to each. The value of U need not be measurable by any analyst, but the consumer must be able to invariably discern between less-preferred and morepreferred combinations of goods. We will refer to each such combination as a basket of goods.

2.

Consistency. This assumption insures that thought experiments can be carried out. The consumers utility function (often referred to as preferences) is constant throughout the experiment (price change, income change, etc.) Whimsical behavior is not allowed in the model.

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3.

Transitivity. If the consumer judges basket A better than basket B, and the consumer judges basket B better than basket C, then the consumer must judge basket A better than basket C. This condition is a sine qua non for rational behavior.2

4.

More is preferred to less. This assumption assumes that the consumer cannot get so much of any good that the good becomes a bad. For any given levels of X2, X3, , XN and the Ys, having more of X1 makes the consumer better off (results in a higher utility level). This assumption can be relaxed for some goods without changing the models results. The rational consumer who can choose how much of each X to consume will simply never consume so much of any good that the additional units become obnoxious. If the good is obnoxious from the beginningsay air pollutionthen we rename the good air pollution abatement.

4.1.2.

Depicting the Utility Function To illustrate the concept of the utility function, we employ a model in which utility is a

function of two goods, X and Y. This representation has obvious advantages for the purpose of graphing. As it turns out, most of the important principles of consumer behavior can be developed within this relatively simple framework. To use Excel requires that we be more restrictive. The function that we employ is the following: U = X0.7Y0.3. (4.2)

This is an example of the widely-used Cobb-Douglas function.3 Because a negative number raised to a power does not yield a real value, U cannot be defined until the consumer has just over
2

One should not take this condition for granted. A well-known problem of making decisions on the basis of majority rule is that preference orderings based on such a rule will not in general satisfy this fundamental requirement for rationality. 3 The Cobb-Douglas function was developed to examine production behavior. The original function was of this form: Q = AL K1- , where A is a constant, L is labor, and K is capital. The two exponents sum to 1.0 by construction. As applied to consumer behavior, this model proves quite restrictive. It implies, among other things, that the consumer always spends the same fraction () of his/her income on good X, no matter what the income level or the prices of X and Y. In our variation, the person spends an increasingly large share of income on X as income increases. 4 -3

five units of Y. Think of five units of Y as being necessary for survival. We examine the behavior of the consumer whose utility is represented by this function throughout this chapter. We will note where the functional form is more restrictive than is required by the four conditions stated above. Figure 4.1 shows how utility depends on the levels of X and Y. Two aspects of the utility hill depicted in the figure are apparent. First, utility increases with the increased consumption of either X or Y, given values of the other. The other is that the rate at which utility increases becomes smaller as we move along the hill in either direction. This utility function exhibits diminishing marginal utility: as the amount of one good increases, holding constant the other good, the additions to utility decrease.

Figure 4.1 Utility Function

Figure 4.2 shows this relationship more clearly. In Figure 4.2, the level of good Y is held constant at Y = 10 so that utility becomes a function of X alone. As X increases, so does utility

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but at an ever-decreasing rate. This characteristic of diminishing marginal utility is not imposed by theory. Any function like this one would yield the same behavior pattern as the one employed: U = X0.7 Y0.3 , Where (lambda) and (mu) are positive numbers. If > 2 in this example, the slope of the curve in Figure 4.2 would increase as X increases, holding Y constant. We select exponent values below unity, not because theory dictates that this be so, but because diminishing marginal returns seem plausible.

Figure 4.2 Utility as a Function of One Good =========== Review Questions and Exercises (Refer to the workbook Utility and Demand.xls.) 1. Does the Cobb-Douglas utility function represented in the worksheet Utility Function exhibit the four characteristics that economists assert a utility function should exhibit? Explain. 2. In the worksheet Utility Function each of the lines from the origin toward the east shows how utility increases as X increases, given a certain level of Y. Think of moving along one of the lines as walking up a utility hill. Describe the path, referring to the line nearest to the front of the graph. Does this path reflect diminishing marginal utility? Explain. 3. When Y = 5 units, the gain in utility from increasing X from 10 to 20 units is ______ units of utility, or ______ units of utility per unit of X. When Y = 10 units, the gain in utility from increasing X from 10 to 20 units is ______ units of utility, or ______ units of utility per unit of X.
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4. a. Refer to the worksheet Utility Function, One Good. Given Y = 15 units, the marginal utility of X between X = 10 units and X = 20 units is ______ units of utility per unit of X; between X = 20 units and X = 30 units, the marginal utility of X is ______ units of utility per unit of X. (Marginal utility of X = Utility/X, holding levels of other goods constant.) b. Given Y = 30 units, the marginal utility of X between X = 10 units and X = 20 units is ______ units of utility per unit of X; between X = 20 units and X = 30 units, the marginal utility of X is ______ units of utility per unit of X. 5. In Cells C15:E16, change the exponent on X from 0.5 to 0.75 and repeat 4(a). Given Y = 15 units, the marginal utility of X between X = 10 units and X = 20 units is ______ units of utility per unit of X; between X = 20 units and X = 30 units, the marginal utility of X is ______ units of utility per unit of X. Change the exponents back to 0.5 before saving the workbook. ===========

4.2

Indifference Curves A striking feature of the surface area of the utility hill in Figure 4.1 is the horizontal

bands that cross it. Each of the bands corresponds to a range of utility values. A more common and more useful representation of such bands are indifference curves. These are iso-utility curves, curves consisting of X, Y pairs that yield the same level of utility. Figure 4.3 shows each such curves. Each of these curves corresponds to a line drawn around the utility hill and then projected downward onto the X, Y surface.

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Figure 4.3 Indifference Curves

An indifference curve illustrates one of the important aspects of economics, substitution. The height of the indifference curve at any given point indicates how many units of Good Y this person is willing to give up to get an additional unit of Good X, because changing baskets does not change the consumers utility level. This slope is often called the marginal rate of substitution. This utility function, like most, exhibits a diminishing marginal rate of substitution: If the consumer has more units of X and less of Y, the consumer is willing to give up fewer additional units of Y in order to receive an additional unit of X. (At the lower levels of utility, by the time the consumer gets 20 or so units of X, the amount of Y he/she is willing to give up for more X is virtually zero.) The phenomenon of a diminishing rate of marginal substitution can be related to the concept of diminishing marginal utility. At any point on the indifference curve, the marginal rate of substitution (MRS) is the ratio of the marginal utilities of the two goods: MRS = MUX/MUY. (4.3)

A diminishing rate of marginal substitution does not require diminishing marginal utility for either good, only that the ratio of the two decrease as the consumer moves to the southeast along an indifference curve (consuming more X and less Y). It is constructive to see how the four curves in Figure 4.3 were created in Excel. The following pairs of X and Y were specified and the resulting utility levels computed, using Equation (4.2).

Table 4.1 X, Y, and Utility

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Next, the levels of Y required to yield each of the four utility levels were determined using this relationship:4 Y = U4/X2 (4.4)

The four values of U from the table above yield four distinct indifference curves.5 One of the pairs (5,10) is represented in Figure 4.3. The graph reflects the more is better requirement in a direct fashion. All points to the southwest of (5,15) necessarily lie on lower indifference curves; all points to the northeast necessarily lie on higher indifference curves. To determine whether points to the northwest or southeast of (5,10) requires more information, the sort that the specific utility function provides.

=========== Review Questions and Exercises (Refer to the workbook Utility and Demand.xls.) 1. Refer to the worksheet Utility Function. Again think of walking along the utility hill but now from the southeast to the northwest. Walking along a line that separates any two color bands corresponds to walking on a path for which all points lie at the same elevation. In terms of quantities of X and Y, what change occurs as you walk from the nearest (southeast) corner toward the northwest corner? 2. Refer to the worksheet Indifference Curves. Describe how an indifference curve relates to the path that you described above. 3. Explain how the shape and location of the indifference curves reflect the four characteristics of a utility function. 4. Change the value of Y, leaving X values unchanged. The new value of Y is ______. Two indifference curves appear to shift. Actually, the existing utility curve vanishes to be replaced by two ones. Do the new indifference curves pass through the points in the table? Must they? Explain. 5. In terms of preferences, interpret the fact that (the absolute value of) each indifference curves slope decreases as X increases.
4 5

U = X0.5Y0.25 implies Y1/4 = U/X3/4, so Y = U4/X3. While the lower two indifference curves become very close to each other, examination of Equation (4.4) confirms that they cannot cross. This is a general characteristic of a map of indifference curves. If two were to cross, the transitivity condition would be violated. 4 -8

===========

4.3.

Budget Constraints and Constrained Maximization Utility is just half of the story. Every consumer faces one or more constraints on which

baskets are available for consumption. Most apparently, money income is limited. In addition, time is limited. This chapter is limited to the discussion of the former. Labor economics textbooks often incorporate the time constraint as well when discussing choices between leisure and goods and services purchased in markets.

4.3.1.

The Budget Constraint The consumer behavior model developed here employs the following assumptions: all

goods under consideration are market goods, the consumer must pay the same price per unit no matter how few or many she/he consumes, and the consumers money income is fixed. Each of these could be replaced with other assumptions. Consumers could enjoy home-produced goods and services (we all do). The consumer could receive quantity discounts or, in rare cases, she/he could buy so much of a good that the price is driven up. Finally, the consumer model could be extended to encompass decisions about how much to work and, therefore, how much income to have. To keep the analysis tractable and to combine it with the analysis of indifference curves, we assume that the consumer purchases two goods, X and Y. The assumptions in the preceding paragraph imply a budget constraint of the following form: PXX + PYY = M, (4.5)

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where PX and PY are the prices of the two goods and M is money income.6 One such budget line, where M = $165 per period, PX = $5 per unit of X and PY = $8 per unit of Y appears in Figure 4.4 below.

Figure 4.4 A Budget Line

The endpoints are X = 33 (M/PX = $165/$5 = 33 units of X) and Y = 20.625 (by similar calculation). The slope is (-)20.625/33 = (-)0.625, which is the value of PX/PY. Given the assumptions of the model, the budget lines slope is always the ratio of the product prices.7 A change in either the price of one of the goods or of money income will shift the budget line. An increased money income does not affect the slope of the budget line, but shifts the budget line in a parallel fashion. Changing either price causes the budget line slope to change. (Of course, if all prices and income were to change in the same proportion, say double, then the budget line would not change at all.) Figures 4.5 and 4.6 show the effects of an increased price of good Y and of a decreased money income.
6

The consumer cannot save in this model. To allow saving would be to add an additional product: X or Y in the future. The model can be extended easily to incorporate saving. 7 Confirm this by rewriting the equation for the budget line as Y = M/PX (PX/PY)X 4 -10

Figure 4.5 shows the effect of reducing the consumers money income from $165 to $135. The slope remains (-)0.625 ($5/$8). Figure 4.6 demonstrates that an increase in the price of good Y pivots the budget line inward along the Y-axis. Now the budget line lies below the original line (except at Y = 0) and has a slope of (-)5/12).

Figure 4.5 Effect of Reduced Income

Figure 4.6 Effect of Increase PY =========== Review Questions and Exercises (Refer to the workbook Utility and Demand.xls.)

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1. Refer to the worksheet Budget Line. Calculate the values of the budget lines endpoints given the data at the left of the graph. 2. Explain verbally why the slope of the budget line is PX/PY. 3. a. (Not necessarily in Excel.) Suppose that this consumer can buy between 0 and 15 units for a price of $5 per unit, but that the price falls to $4 for all units beyond the 15th. Draw the consumers budget line. b. (Not necessarily in Excel.) Suppose that this consumer can buy between 0 and 15 units for a price of $5 per unit, but must pay a $3 surtax on all additional units, driving the price up to $8 per unit. Draw the consumers budget line. 4. Refer to the worksheet Budget Line (2). a. Change M without changing either price. The new value of M is $______. Describe the relationship between the original budget line and the new one. b. Reset the values. Now choose a new value for PX. The price of good X is $______ per unit. Describe the relationship between the original budget line and the new one. c. Reset the values. Now choose a new value for PY. The price of good Y is $______ per unit. Describe the relationship between the original budget line and the new one. 5. Reset the values. Then set M = $195 and PX = $7, keeping PY = $8. Do you think these changes make the consumer worse off, or better off. What more would you have to know before answering this question. (Hint: You would not have to know the consumers preferences, but you would have to know something about her behavior.) ===========

4.3.2

Utility maximization subject to the budget constraint The utility function reflects the consumers preference. The budget line reflects the

consumers options. The two are inherently unrelated. What brings the two together is rational behaviorthe consumers efforts to achieve the maximum possible utility level. The consumer can control one thing, the combination of X and Y. He/she does this in a way that leads to the highest possible indifference curvethe one farthest to the northeast. Figure 4.7 shows how the budget line and indifference curves depict the utility-maximizing basket of X and Y.

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Figure 4.7. Achieving Maximum Utility

The consumer may choose any point on the budget line. All but one are suboptimal. Four such points are those defined by the intersection of the budget line and Indifference Curves 1 and 2. The single optimal point (basket of goods) is the one at which the slope of the indifference curve equals the slope of the budget line. Recall that the slope of the indifference curve, the marginal rate of substitution, equals the rate at which the consumer is willing to exchange X for Y. The slope of the budget line shows the rate at which the consumer can affect such exchange. Yet another view of this point of tangency follows from these two facts: the slope of the budget line is (-)PX/PY and the slope of the indifference curve is (-)MUX/MUY. This implies that the utility-maximizing consumer will choose the basket at which PX/PY = MUX/MUY, or MUX/PX = MUY/PY (4.6)

The intuitive content of this equation is straightforward. The consumer maximizes utility by choosing a basket such that, at the margin, she/he gains the same utility from the marginal dollar spent on each of the two goods. If this person were given a small increment in income she/he would achieve the same additional utility by spending that increment on either X or Y.

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4.4.

Maximization in Excel The graph above illustrates the nature of the optimization but is drawn without access to

advantages that Excel offer. In particular, Excel contains an optimization routine, Solver, that can determine precisely the values of X and Y that maximize a specific utility function subject to a given budget line. Figure 4.8 shows the solution to this problem for the values we have been employing to this point.

Figure 4.8. Utility Maximization

The comment in the graph above refers to Excels Solver, which determines that the consumers utility is maximized when the $165 is spent to buy 23.1 units of X and 6.188 units of Y. To see how it reaches this conclusion consider Figure 4.9, which shows the information the user provides in order to achieve this result.

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Figure 4.9. A Solver Dialog Box

Tell Solver that the objective function is found in Cell B7 and that this function is to be maximized. In Figure 4.8, this is the cell to the right of U* =. It contains the function =b7^.5*b7^.3the utility function. Excel does not know, however, where the value of X and Y are located. Give it this information in the By Changing Cells: box. Finally, constraints must be imposed. The only economically meaningful constraint is the budget constraint: b6 = b4/b3 (b2/b3)*b5. The other two constraints should always be added, however. Without these nonnegativity constraints, Solver can sometimes yield absurd results with negative quantities of X and/or Y.

4. 4.1

Income Changes With Solver at our service, we can examine the effects of income and price changes on

the basket chosen by this consumer. We begin with a change in the consumers income level, from $240 to $210. Figure 4.10 shows the effect of this change.

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Figure 4.10 Income Change

The calculations to the left of the graph reveal some details not immediately obvious in the graph. In particular, we see that income, consumption of X, and consumption of Y all change in the same proportion. This is a characteristic of the Cobb-Douglas utility function, but certainly not of utility functions in general. This phenomenon can be stated in other terms. Graphically, a line draw through all points of tangency of indifference curves and parallel budget lines, the income-consumption curve, is a ray though the origin: the ratio of Y to X is always the same. In terms of elasticities, the income elasticity of both goods is unity. This implies that the consumer always spends the same fraction of income on each good, whatever the income level.8

4.4.2

Price Changes How the consumer responds to a change in the price of a good can analyzed within the

same framework. Let the price of Good X change from $10.00 to $6.00. The budget line pivots to the right and results in an increase in consumption of X from 16 units to 262/3 units. The reduced price increases the quantity consumed of Good X for two reasons: X is now less costly relative to
8

Also, both goods must be normal goods. A normal good is one for which an income change implies a quantity change in the same direction, other things constant. With a Cobb-Douglas utility function, all goods must be normal goods. 4 -16

Good Y, so the consumer has an incentive to substitute X for Y. Furthermore, as Figure 4.10 demonstrates, the consumers real income has increased. That is, the consumer can now purchase combinations of X and Y that the budget had previously precluded.

Figure 4.10 Price Change, No Compensation

In terminology typically used in economic analysis, the price change has two effects, a substitution effect and an income effect. As we see below, both work in the same direction for this good. This is a normal good, one for which a higher income would result in more consumption even if the price had not fallen. But the price did fall, adding to the consumers incentive to consume more of the good. As we have seen previously, the Cobb-Douglas utility function is much more restrictive than the basic assumptions require. In the case of the price level change, the consumption of X changes exactly in proportion to the price change. That is, the elasticity is 1.0. This implies that the amount the consumer spends on good X stays the same as the price changes. Indeed, for all income levels and all price levels, the fraction of income spent on this good remains the same. We emphasize that these results apply with the Cobb-Douglas function, which we use for illustration purposes because it is relatively easy to manipulate, but not with utility functions in general.

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The fact that the consumer spends the same amount of money whatever the price of X implies that the amount spent on Y remains constant. Furthermore, the price of Y is held constant, so the quantity of Y is the same for all prices of X. Thus, we can construct a price-consumption curve, showing the quantities of X and Y for all prices of X. The price-consumption is a horizontal line. If the percentage change in the quantity of X were less than the percentage change in PX, the consumer would have more money to spend on Y, so the price-consumption curve would slope upward. Likewise, if the percentage change in X exceeds that in PX, the consumer would spend more on X are the price decreases, leaving less money to spend on Y, so the priceconsumption curve would slope downward. Again, with the Cobb-Douglas utility function, all goods are normal goods, for which consumption of a good and the income level move in the same direction. For another class of goods, inferior goods, higher income causes reduced consumption. For such goods, it is theoretically possible (though quite unlikely) for a price reduction to cause the consumer to buy less of the good. This is because the consumers real income rises, causing less of the good to be purchased at each price. The price reduction, however, militates toward increased consumption of the good. Which effect dominates is an empirical fact, not predicted by theory.9 For some purposes, it is important to consider the effect of a price change when the consumer is compensated for the price change. In this example, since the consumer enjoys a price decrease, such compensation would involve taking away money income in a way that offsets the price change. This may be done in various ways. The easiest way is to construct a price index. A common price index is one that allows the person to buy the initial bundle of goods at the new set of prices. Figure 4.11shows the effect of this sort of compensation. In this example, reducing income from $165 to $118 would enable the consumer to continue consuming

Theory does explain, however, why the income effect will typically not dominate. Most goods take up a large fraction of most consumers incomes. Therefore, the price change for the single good is unlikely to change the consumers income by much, so the income effect is likely to be small. 4 -18

23.1 units of X and 6.188 units of Y. The graph reveals, however, that the consumer will not do so.

Figure 4.11 Price Change with Price Index Compensation

Up to this point, Solver has not been implementedthe consumer has not reacted to the price change. The graph reveals, however, that the consumer can move to a higher indifference curve by increasing X consumption and decreasing Y consumption. This combination of a price change and a price-index based compensation leaves the consumer better off. Figure 4.12 below shows in another way that the price index approach overcompensates the consumer. Reducing money income to $115.40 allows the consumer to return to the initial indifference curve. In terms of utility, this compensates the consumer fully for the price reduction. Thus, the price index approach to compensation would give the consumer about 3 percent (($118.80 - 115.40)/115.40) more income than full compensation requires.

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Figure 4.12 Price Change with Full Compensation

We may now see how the changed price of X causes the quantity consumed of this good to change. The substitution effect, with the consumers utility level held constant, is from 16 units of X to 18.973 units, or 2.973 units. The remainder of the change (7.694 units) is due to the increased income implicit in the price reduction. The income effect is relatively large because we consider a two-good consumption basket and the consumer spends 2/3 of his/her income on Good X. Generally, the income effect is quite small because such a small fraction of ones income is typically spent on any single good.10

=========== Review Questions and Exercises (Refer to the workbook Utility and Demand.xls.) 1. Refer to the spreadsheet Indifference Curves (2). Given that M = $165, PX = $5, and PY = $8, determine the income level this consumer must have in order to be on the highest indifferences curve, Indifference Curve 4, corresponding to U = 6.887. M = $______, X = ______, Y = ______. (All values will be approximate.)

The uncompensated elasticity is determined as follows: eu = ec - eI, where: eu is the uncompensated elasticity, ec is the compensated elasticity, is the share of income spend on the good, and eI is the income elasticity. For good X, -1.0 = -(1/3) (2/3)(1). The value 0.34 in Figure 4.12 reflects slight rounding error and should be 0.3333.
10

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2. a. Change PX to $9, holding income at the level determined in (1), and PY = $8.. The consumers utility level falls to approximately ______. The new level of X is approximately ______, and the new level of Y is approximately ______. b. Compensate the consumer for the misfortune suffered in (a). In order for the consumers initial utility level to be restored, M must increase to approximately $______. At this level of M, the level of X consumed is approximately ______, and the level of Y consumed is approximately ______. c. Can you determine whether X is a normal good or an inferior good, based on (a) and (b)? Explain. 3. Refer to the spreadsheet Utility Maximization. Repeat (2). Use the cursor to place the value indicated into the appropriate cell, and then execute Solver to determine the solution. Do this by selecting Solver from the Tools menu. a. M = $145 (from (1)), PY = $8, PX = $9. X = ______, Y = ______, and U = ______. b. M = $215 (from (2(b))), PY = $8, PX = $9. X = ______, Y = ______, and U = ______. 4. Interpret the fact that utility is maximized at the point at which an indifference curve is tangent to the budget line. Phrase your interpretation in terms of what the consumers is willing to do and what the consumer is able to do. 5. a. Use the scroll bar in the spreadsheet Income Change to select an income level other than M = $165. The income level is $______. Now execute Solver to determine the new levels of X and Y; these levels are X = ______ and Y = ______. b. The Income-Consumption Curve (ICC) shows the Y, X pairs at each income level, given the prices of X and Y. For the utility function chosen, the ICC is a straight line through the origin. What does this mean in terms of consumer behavior? 6. Use the scroll bar in the spreadsheet Price Change, No Compensation to choose a new price of Good X. Execute Solver to determine how the consumer reacts to the price change. a. The new price level is PX = $______. At this price X = ______ and Y = ______. b. The Price-Consumption Curve (PCC) is a horizontal line, given the utility function employed in the workbook. What does it mean to say that the PCC is horizontal? c. The price elasticity of (uncompensated) demand for Good X is 1.00 given the utility function employed in the workbook. Explain how The PCC is horizontal and The elasticity of demand is 1.00 are the same statement. (Hint: If PCC is horizontal, how much is spent on Y at each price of X?) 7. a. Use the scroll bar in the spreadsheet Price Change with Compensation to select a new price. For the moment, select a price either lower than $4 or higher than $7. Do not execute Solver. The price chosen is PX = $______. At this new price, M = $______ would be required to purchase the initial bundle of X and Y. (You may either calculate this value or read it off the table.) b. Look at the graph. Explain why giving this person the amount of money indicated in (a) would result in overcompensation for the change in the price of Good X. c. Before executing Solver, change PX to the value used in (6). Now execute Solver. Compare the results of the change on this spreadsheet with those on the previous one. d. You can now compute the income and substitution effects due to the price change. When the price level of Good X changed from PX = $5 to PX = $______ and income remained at M = $165, the quantity consumed of X changed from X = 22.000 to X = ______. When M changed from M = $165 to M = $_______, to compensate the consumer, X changed

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from X = 22.000 to X = _______, or by ______ units. This is the substitution effect. The remainder of the change, ______ units, is the income effect. 8. Print the graph that appears on the spreadsheet Price Change, both. Use a pencil to show the income effect and the substitution effect of the price change. ===========

4.5

The Model of Consumer Behavior and the Individuals Demand Curve While the model developed above can illustrate and illuminate various aspects of

consumer behavior, it suffers from one important drawback: it is invisible. We can never see any consumers thought process. We can, however, see the effects of this behavior in the form of a demand curve, at least in principle. A demand curve is a functional relationship that shows the quantity of a good that a consumer (or group of consumers) is willing and able to purchase at each of a set of prices, other things equal. Demand curves are not directly observable, but they can often be estimated to a sufficient degree of precision to guide policy. One reason that policymakers would be interested in a demand curve would be to estimate the consumer surplus that a specific policy action would generate or destroy. Consumer surplus is the difference between what a consumer is willing and able to pay for a certain amount of a good and what the consumer actually pays. Refer to Figure 4.13 and, for the moment, look at the Uncompensated Demand Curve. Clearly, the consumer is willing and able to pay more than $10 for all units up to X = 16. If the price is $10, then the consumer gains surplus by paying $160 for the 16 units when she/he would have been willing to pay more. We cannot say how much more the consumer would be willing and able to pay, so we cannot know total consumer surplus.

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Figure 4.13 Demand Curves

Fortunately, for most important issues one need not know total consumer surplus. Indeed, trying to determine total consumer surplus may be a meaningless exercise, since it requires placing a willingness to pay on each unit of the good. For some goods like water, such a construct makes little sense. A more interesting (and answerable) question is this: What is having the price of this good reduced from $5 to $3 worth to the consumer? That is, what additional consumer surplus is generated? We know the answer is $49.60 (= $165 - $115.40) because we have seen the consumers utility function. Suppose, however, that we saw only the consumers demand curve for this product. The uncompensated demand curve passes through the quantities X = 23.1 (at PX = $5) and X = 38.5

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(at PX = $3). The consumer gains surplus for two reasons. The larger reason in this case is that she/he can now buy the 23.1 units for $2 less per unit, adding $46.20 to her/his surplus. In addition, the 15.4 units between X = 23.1 and X = 38.5 are worth more than $3. The demand curve indicates that the consumer gains $59.00 in value. This would imply that taking this much money from the consumer would compensate for the reduced price. We know, however, that the actual compensation that would leave the consumer better off is only $49.60. We see that the consumer surplus estimate generated by the uncompensated demand curve seems to overstate the actual gain by a significant amount. This happens because the uncompensated demand curve, by construction, allows an income effect of the price change, while compensation involves removing just enough income to determine precisely what the price reduction is worth to the consumer. While this result is bothersome, it should be placed in context. As noted before, the income effect is small for most goods. Indeed, research has shown that the difference between the values generated by the (observable) uncompensated demand curve and the (appropriate) uncompensated curve will, in general, be quite small. (Willig (1976) and Heckman (1981) examine this issue. A second point is that, though the difference between the two numbers above ($59.00 and $49.60) may seem rather large, it is likely to be small compared to the imprecision in estimating demand curves.

=========== Review Questions and Exercises (Refer to the workbook Utility and Demand.xls.) 1. On the spreadsheets Price Change, no Compensation and Price Change with Compensation set the price of Good X at $3 and execute Solver. Now refer to the spreadsheet DemandCurves. Explain why is the uncompensated demand curve is more elastic than the compensated demand curve. 2. Explain why the area to the left of the demand curve between the two prices corresponds to Consumer Surplus. Refer to Chapter 3 as needed.

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3. An obvious problem with the discussion in question 2 is that the spreadsheet shows two demand curves. (If we had started with PX = $3 and raised it to PX = $5, making the requisite compensation, we would have yet a third demand curve.) a. Which of the two demand curvescompensated or uncompensatedgives the larger value for Consumer Surplus? What are the values? b. Which of the two values corresponds to the compensation needed to keep the consumer at the original utility level? =========== 4.6. Chapter Summary This chapter introduces a model of rational behavior. The consumer whose behavior is being analyzed is assumed to be rational. More specifically, the consumer has tastes which do not vary as a result of price or income changes and which yield transitive preference orderings among possible bundles of goods. The behavior of such a consumer is analyzed assuming that the consumers preferences are defined by a Cobb-Douglas utility function. The consumers responses to income changes and to price changes are examined. Implications of the model for the consumers demand for a product are examined. Furthermore the reasoning is reversed: Given an observed demand, the chapter addresses the question of how to determine the effect of a price change on the consumers level of well-being, as measured by the change in the Consumer Surplus.enjoyed by this consumer.

4.7.

Looking Ahead This model of consumer behavior is used subsequently in the analysis of a general

equilibrium system (Chapter 15), one in which prices and income levels are all determined inside the model. The next few chapters turn to the other side of the market, to producers. They develop the implications of production functions, which are quite similar to utility functions, for sellers and for the types of markets in which they function.

New Terms

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Hausman, J. A. 1981. Exact consumers surplus and deadweight loss. American Economic Review 71, 66276.

Willig, R. 1976. Consumers surplus without apology. American Economic Review 66, 58997.

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