Chapter 6 – Stiglitz

Budget constraint

Income elasticity
cross-price elasticity

Normal/inferior goods

 

How do consumers make choices?

Given their budget, the prices of goods and their preferences (utility) they decide what to buy.

(What factors go into determining each of these factors?)

Given a set of prices and income, we can draw a budget constraint for a consumer.

Suppose p₁= $10 (cake) and p₁= $20 (shoes).

How many of each can a person afford, with an allowance of $100?

 

Imelda Marcos

 

cake     shoes

10        0

8                    1

6          2

4          3

2          4

0          5         

 

Can graph these points to get budget constraint.

The slope of the budget constraint depends on the prices of the goods. (rise over run)

 

What happens if the price of a good changes? The line will rotate. (see graph)

Assume for instance that price of cake doubles.

 

Cake    Shoes

5          0

4                    1

3          2

2          3

1          4

0          5         

What’s the slop now?

 

What if the person’s income changes? Suppose Imelda loses ½ her allowance? (assume original prices)  The line will shift (parallel)

 

Cake    Shoes

5          0

3                    1

1          2

0          2.5

 

Given the various possible combinations of points where one can consume, what determines where a consumer ends up?

His or her own tastes and preferences (which are in turn influenced by other things, such as marketing, etc.)

 

Suppose Imelda is on her original budget constraint, consuming 4 cakes and 3 pairs of shoes.

 

How will a person’s choices change if either price or income change?

Income elasticity – How will an increase or decrease in income affect consumption of a good.
Income elasticity can be negative or positive and can be greater or less than 1.

Most goods are “normal.” This means that as income increases, consumption of those goods increases.

What goods can you think of with income elasticities less than 0 or greater than 1?

 

Looking again at the budget constraint, we can ask, where will a person end up as a result of a price change. As the price rises, the quantity demanded declines. What do we call that? own price elasticity.

When price changes, this also affects the relative prices of goods.

 

In other words, because you have to pay more for cake, we may also buy fewer pairs of shoes. If as a result of a rise in the price of cake, someone buys fewer pairs of shoes, what do we call it? Cross-price elasticity (for complements.)

 

It turns out that this is how the demand curve is derived – by examining how a person’s consumption changes, as a result of price changes.

(see graph).

Why do economists care about the elasticity of demand?

For marketing purposes – a firm needs to know how increasing their price is likely to change the quantity demanded of a good, and vice versa.

For policy reasons – a rising price has a differential impact on different consumers. (distributional question)

Ex: energy tax; cigarette tax.