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Finance 510:

Microeconomic
Analysis
Consumer Demand Analysis

Suppose that you observed the following consumer behavior

P(Bananas) = $4/lb.

Q(Bananas) = 10lbs

P(Apples) = $2/Lb.

Q(Apples) = 20lbs

P(Bananas) = $3/lb.

Q(Bananas) = 15lbs

P(Apples) = $3/Lb.

Q(Apples) = 15lbs

Choice A

Choice B

What can you say about this consumer?

Choice B

Is strictly
preferred to

Choice A

How do we know this?

Consumers reveal their preferences through their observed choices!

P(Bananas) = $4/lb.
P(Apples) = $2/Lb.

P(Bananas) = $3/lb.

Q(Bananas) = 10lbs

Q(Bananas) = 15lbs

Q(Apples) = 20lbs

Q(Apples) = 15lbs

Cost = $80

Cost = $90

Cost = $90

Cost = $90

P(Apples) = $3/Lb.

B Was chosen even though A was the same price!

What about this choice?


Choice C
P(Bananas) = $2/lb.

Q(Bananas) = 25lbs

P(Apples) = $4/Lb.

Q(Apples) = 10lbs
Q(Bananas) = 15lbs

Choice B

Cost = $90

Cost = $90

Q(Apples) = 15lbs
Q(Bananas) = 10lbs

Choice A

Choice C

Cost = $100

Q(Apples) = 20lbs

Is strictly
preferred to

Choice B

Is choice C
preferred to choice
A?

Choice B

Choice C

Is strictly
preferred to

Choice A

Is strictly
preferred to

Choice B
C>B>A

Choice C

Is strictly
preferred to

Choice A

Rational preferences exhibit transitivity

Consumer theory begins with the assumption that every


consumer has preferences over various consumer
goods. Its usually convenient to represent these
preferences with a utility function

U :A B
A
Set of possible
choices

B
Utility Value

Using the previous example (Recall, C > B > A)

Choice A
Q(Bananas) = 10lbs
Q(Apples) = 20lbs

Choice B
Q(Bananas) = 15lbs
Q(Apples) = 15lbs

Choice C
Q(Bananas) = 25lbs
Q(Apples) = 10lbs

U (25,10) U (15,15) U (10,20)

We only require a couple restrictions on Utility functions


For any two choices (X and Y), either U(X) > (Y), U(Y) > U(X), or
U(X) = U(Y) (i.e. any two choices can be compared)

For choices X, Y, and Z, if U(X) > U(Y), and U(Y) > U(Z), then
U(X) > U(Z) (i.e., the is a definitive ranking of choices)

However, we usually add a couple additional restrictions to


insure nice results
If X > Y, then U(X) > U(Y) (More is always better)
If U(X) = U(Y) then any combination of X and Y is preferred to
either X or Y (People prefer moderation to extremes)

Suppose we have the following utility function

U U ( x, y )

U = 20

Imagine taking a cross section at some utility level.

The cross section is called an indifference curve


(various combinations of X and Y that provide the same
level of utility)
Any two choices can be compared

U ( A) U ( B ) 20

There is a definite ranking of all


choices
A

U (C ) U ( A) U (C ) U ( B )

U ( x, y ) 25
B

U ( x, y ) 20

The cross section is called an indifference curve


(various combinations of X and Y that provide the same
level of utility)
More is always better!

U (C ) U ( A)

C
A

U ( x, y ) 20
x

The cross section is called an indifference curve


(various combinations of X and Y that provide the same
level of utility)
People Prefer Moderation!

U (C ) U ( A)
A
C

U ( x, y ) 20
x

The marginal rate of substitution (MRS) measures the amount of Y


you are willing to give up in order to acquire a little more of X

U ( x * x, y * ) U ( x * , y * )

*
*
*
+ U ( x, y y ) U ( x , y )

y
x
y*

Suppose you are given a little


extra of good X. How much Y is
needed to return to the original
indifference curve?

U ( x, y ) k

x*

=0

The marginal rate of substitution (MRS) measures the amount of Y


you are willing to give up in order to acquire a little more of X

U ( x* x, y * ) U ( x * , y * )
U ( x, y * y ) U ( x* , y * )
y = 0

x +

x
y

y
x
y*

Now, let the change in X become


arbitrarily small

y
U ( x, y ) k

x*

The marginal rate of substitution (MRS) measures the amount of Y


you are willing to give up in order to acquire a little more of X

U x ( x* , y * )dx U y ( x* , y * )dy 0

y
y

Marginal Utility of X

Marginal Utility of Y

dy
U x ( x* , y * )
MRS

dx
U y ( x* , y * )

U ( x, y ) k

x*

The marginal rate of substitution (MRS) measures the amount of Y


you are willing to give up in order to acquire a little more of X

MRS ( x* , y * ) MRS ( x' , y ' )

If you have a lot of X relative to Y, then X is


much less valuable than Y MRS is low)!

y*

y'

U ( x, y ) k

x'

An Example

U ( x, y ) x y
U x ( x, y ) x 1 y

U y ( x, y ) x y

U x ( x* , y * ) x 1 y y
1
*
*
U y ( x , y ) x y
x

The elasticity of substitution measures the curvature of the


indifference curve

y

x

y
%
x

%MRS

'

y
d
MRS x

y d MRS

x

y

x
x

An Example

U x ( x, y ) x

U ( x, y ) x y
1

U y ( x, y ) x y 1

x
d MRS
d

U x ( x * , y * ) x 1 y y
1
*
*
U y ( x , y ) x y
x

y

x

1
y

x

Consumers solve a constrained maximization maximize


utility subject to an income constraint.

max U ( x, y )

x0, y 0

subject to

px x p y y I

As before, set up the lagrangian

( x, y, ) U ( x, y ) ( I p x x p y y )

( x, y, ) U ( x, y ) ( I p x x p y y )
First Order Necessary Conditions

x ( x, y , ) U x ( x, y ) p x 0

y ( x, y, ) Uy ( x, y ) p y 0

U x ( x, y ) Px

U y ( x, y ) Py

( x, y, ) I p x x p y y 0
px x p y y I

U y ( x, y )
py

U x ( x, y )

px

max U ( x, y )

x0, y 0

subject to

px x p y y I

y
x* x( p x , p y , I )

I
py

y * x( p x , p y , I )
*

I
px

.5

max x y

.5

x0, y 0

subject to

px x p y y I

( x, y, ) x y ( I p x x p y y )
.5

.5

U x ( x, y ) .5 x .5 y .5 Px

.5 .5
U y ( x, y ) .5 x y
Py

Px
x
y
P
y

px x p y y I

.5

max x y

.5

x0, y 0

subject to

px x p y y I

px x p y y I
Px
xI
p x x Py
P
y

I
x
2 px
I
y
2 py

Suppose that we raise the price of X

Can we be sure that demand for x will


fall?

y
I
py

y*

I
px

Suppose that we raise the price of X, but at the same time,


increase your income just enough so that your utility is
unchanged

y
U x ( x, y ) Px

U y ( x, y ) Py

I
py

Substitution effect

y*

I
px

Now, take that extra income away

y
I
py

px x p y y I

Income effect

y*

I
px

Demand Curves present the same information in a


different format

px

p' x
px

x'

x*

x'

x*

Demand Curves present the same information in a


different format

px

y
%
x

%MRS

%x
x
% p x

px

x*

Elasticity of Substitution vs. Price Elasticity

px
is small

x is small

x
px

y
is large

x is large

Perfect Complements vs. Perfect Substitutes

px
x 0

(Almost)

x
px

.5

max x y

.5

x0, y 0

subject to
px

px x p y y I

%x
dx p x
x

%p x dp x x

dx
I
2
dp x
2 px

px

x*

I
x
2 px

px
I
x 2
1
2 px I

2 px

Suppose that we raise the price of Y


U x ( x, y ) Px

U y ( x, y ) Py

px x p y y I

I
py

Substitution effect (+)

Income effect (-)

Net Effect = ????

I
px

Cross Price Elasticity

px

%x
dx p y
y

%p y dp y x

px

%x
x*

.5

max x y

.5

x0, y 0

subject to
I
x
2 px
I
y
2 py

px x p y y I

%x
dx p y
y

0
%p y dp y x
Income and Substitution effects
cancel each other out!!

Suppose that we raise Income


U x ( x, y ) Px

U y ( x, y ) Py

Substitution effect = 0

px x p y y I

I
py

y*

x x'
*

I
px

Income effect (-)

Income Elasticity

%x dx I
I

%I dI x

px

px

%x
x*

.5

max x y

.5

x0, y 0

subject to
I
x
2 px
I
y
2 py

px x p y y I
%x dx I
I

%I
dI x
1

2 px

I
1
I

2 px

Willingness to pay

Q 200 2 P

Suppose that we have the


following demand curve

$100

A demand curve tells you the maximum


a consumer was willing to pay for every
quantity purchased.

$50

D
100

For the 100th sale of this


product, the maximum anyone
was willing to pay was $50

Willingness to pay

Q 200 2 P

Suppose that we have the


following demand curve

$100
$75

$50

D
50

100

For the 50th sale of this product,


the maximum anyone was
willing to pay was $75

Consumer Surplus

Consumer surplus measures the


difference between willingness to pay
and actual price paid

Q 200 2 P

$100
$75

Whoever purchased the 50th unit of


this product earned a consumer
surplus of $25

$50

D
50

100

For the 50th sale of this product,


the maximum anyone was
willing to pay was $75

Consumer Surplus

Consumer surplus measures the


difference between willingness to pay
and actual price paid

Q 200 2 P

$100

If we add up that surplus over all consumers,


we get:
CS = (1/2)($100-$50)(100-0)=$2500
$2500

$50
Total Willingness to Pay ($7500)
- Actual Amount Paid ($5000)

$5000
D
100

Consumer Surplus ($2500)

A useful tool
In economics, we are often interested in elasticity as a measure
of responsiveness (price, income, etc.)

%x
x
% p x

dx
%x
d ln x
x
dp x
%p x
d ln p x
px

d (ln x)
x
d (ln p x )

Estimating demand curves


Given our model of demand as a function of income, and prices,
we could specify a demand curve as follows:

xd a0 a1 p x a2 I a3 p y
%x
dx p x
px
x

a1

%p x dp x x
x

xd a0 a1 p x a2 I a3 p y
%x
dx p x
px
x

a1

%p x dp x x
x

px
High Elasticity

Low Elasticity

Linear demand has a


constant slope, but a
changing elasticity!!

Estimating demand curves


We could, instead, use a semi-log equation:

xd a0 a1 ln p x a2 ln I a3 ln p y
%x
dx 1 a1
x

%p x d ln p x x x

Estimating demand curves


We could, instead, use a semi-log equation:

ln xd a0 a1 p x a2 I a3 p y
%x d ln x
x

p x a1 p x
%p x
dp x

Estimating demand curves


The most common is a log-linear demand curve:

ln xd a0 a1 ln p x a2 ln I a3 ln p y
%x
d ln x
x

a1
%p x d ln p x
Log linear demand curves are not straight lines, but have
constant elasticities!

.5

max x y

.5

x0, y 0

subject to

px x p y y I

If we assumed that this was the maximization problem


underlying a demand curve, what form would we use to estimate
it?

ln xd a0 a1 ln p x a2 ln I a3 ln p y
H 0 : a1 1

a2 1

a3 0

Estimating demand curves

px

Suppose you observed the


following data points.
Could you estimate the
demand curve?

Estimating demand curves


A bigger problem with estimating demand curves is the
simultaneity problem.

xd a0 a1 p x a2 I d

px
S

Market prices are the result


of the interaction between
demand and supply!!

px
D

xd x s

Estimating demand curves


Case #1: Both supply and
demand shifts!!

px

Case #2: All the points are due


to supply shifts

px

S
S

D
D
D
D

An example

Demand

Supply

Equilibrium

Suppose you get a random shock


to demand

xd a0 a1 p x a2 I d

xs b0 b1 p x s

x s xd

The shock effects quantity


demanded which (due to the
equilibrium condition
influences price!

Therefore, price and the error


term are correlated! A big
problem !!

Suppose we solved for price and quantity by using the


equilibrium condition

x s xd
a0 a1 p x a2 I d b0 b1 p x s

d s
a2
I

p x
b1 a1
b1 a1

b1 d a1 s
a2
I

x b2
b1 a1
b1 a1

We could estimate the following equations

p x 1I 1
x 2 I 2
The original parameters are related as follows:

a2

1
b1 a1

a2

2 b2
b1 a1

2
b2
1
We can solve for the
supply parameter, but
not demand. Why?

xd a0 a1 p x a2 I d
xs b0 b1 p x s
px

By including a demand shifter (Income),


we are able to identify demand shifts
and, hence, trace out the supply curve!!

D
D
D