2011_lecture11_consumer_theory-2

Consumer Theory (A Graphical Treatment) From Budgets and Preferences to Demand Ahmed Tohamy American University in Cairo November 14, 2025 Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 1 / 41.

Helicopter View: Where We Are & Where We’re Going So far: Markets 101 Demand & Supply: equilibrium, CS/PS, shocks Why markets work: prices coordinate, gains from trade When they don’t: externalities, market power, public goods, information problems &: Theory of Supply (firms) Open up firm: technology & costs (TC, MC, AVC/ATC) Revenues & profit maximization (p = MC under competition) Market supply: horizontal adding up; SR vs LR Now: Theory of Consumer Choice (Demand) Preferences, budget, choice Individual demand: income vs. substitution e!ects Market demand: aggregation & elasticities Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 2 / 41 Monopolie.

Helicopter View: Where We Are & Where We’re Going So far: Markets 101 Demand & Supply: equilibrium, CS/PS, shocks Why markets work: prices coordinate, gains from trade When they don’t: externalities, market power, public goods, information problems &: Theory of Supply (firms) Open up firm: technology & costs (TC, MC, AVC/ATC) Revenues & profit maximization (p = MC under competition) Market supply: horizontal adding up; SR vs LR Now: Theory of Consumer Choice (Demand) Preferences, budget, choice Individual demand: income vs. substitution e!ects Market demand: aggregation & elasticities Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 2 / 41.

Helicopter View: Where We Are & Where We’re Going So far: Markets 101 Demand & Supply: equilibrium, CS/PS, shocks Why markets work: prices coordinate, gains from trade When they don’t: externalities, market power, public goods, information problems &: Theory of Supply (firms) Open up firm: technology & costs (TC, MC, AVC/ATC) Revenues & profit maximization (p = MC under competition) Market supply: horizontal adding up; SR vs LR Now: Theory of Consumer Choice (Demand) Preferences, budget, choice Individual demand: income vs. substitution e!ects Market demand: aggregation & elasticities If time permits Game theory: strategic interaction & market power Major “markets are good” violations with asymmetric information: adverse selection & moral hazard We won’t have time to cover this but it is one of the most important themes in microeconomics. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 2 / 41.

Helicopter View: Where We Are & Where We’re Going So far: Markets 101 Demand & Supply: equilibrium, CS/PS, shocks Why markets work: prices coordinate, gains from trade When they don’t: externalities, market power, public goods, information problems &: Theory of Supply (firms) Open up firm: technology & costs (TC, MC, AVC/ATC) Revenues & profit maximization (p = MC under competition) Market supply: horizontal adding up; SR vs LR Now: Theory of Consumer Choice (Demand) Preferences, budget, choice Individual demand: income vs. substitution e!ects Market demand: aggregation & elasticities Key takeaway Markets usually work well. They fail when actions impose uncompensated e!ects on others: an externality is a cost (or benefit) one agent’s action imposes on someone else. Policy tools align private with social incentives. Externalities before information economics were thought of as exceptions. After the informational economics revolution, it is clear that most markets su!er from externalities and the question is the extent and whether corrective intervention is less or more costly. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 2 / 41.

Roadmap Budgets: what is a!ordable and how prices/income shape choices. Preferences and indi!erence curves: what the consumer wants. Utility as a convenient label for preferences. Best a!ordable bundle: finding the choice graphically. From choices to demand curves. Income changes → Engel curves. Price changes → substitution and income e!ects. Normal, inferior, and (briefly) Gi!en goods. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 3 / 41 laton Suppl Sitter goode Saving duisin.

Budgets Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 4 / 41.

Stauberrier Mangoes Income Ps = 2 Pr = 1 Eit Experaiture ? Income 25 + M1 12 m un enterticher Expensitie on Manger OnStrauberies u um Income TotalEsperatitu 2S + M = 12 Exhausting Income Mangoes 12 - S = 0 , m = /L m = 0 , 6· Straubewil.

A [mome Dies from 12-14 M M = 14 - IS Get * Prie of sta Falls Ps=2 , Ps = 1 M + S = 12 m = 0, S = 12 S = 0, m = 17 M↑/.

Budget Constraint: The Opportunity Set Budget line Quantity of x Quantity of y Income M = 12, prices px = 2, py = 1. pxx + pyy = M. Intercepts: (x, 0) = (6, 0) and (0, 12); slope = → px py = →2. All points on/under the line are a!ordable. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 5 / 41 & -pla Prioratio ~ MarketTradeoff how much the marketsmilling to trade onragainst the offer Orange a.

m = 12 Porage = 2 Pronance = I PoO + PisB -Income un un Expenditure Experdities On orange Onbaraman - Total Expenditure B A Budget Set 12- budget line 2 Orapt B < 12 2Orapt B = 12 ↓ B = 12 -②Orage O T B = 0 , Oraja G ! O B = 12 , O.

How Income Shifts the Budget M=12 M=14 M=10 x y Higher income → parallel shift out; lower income → shift in. Slope (relative prices) unchanged. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 6 / 41 G M X.

How Prices Pivot the Budget px=2 px=1 px=3 x y A price fall in x pivots the budget out along the x-axis (flatter). A price rise pivots it in (steeper). Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 7 / 41 12 Pi = Po = 1 i * Market 1xB + 1x0 = 12 Tradeoff B = 12 - 0 is Change B = 0, 0 = 12 *** 0 = 0 , B = 12 6 %.

Market Tradeoff "wi S O=.

Preference Theory Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 8 / 41.

Preferences: What the Consumer Likes We assume the consumer can compare bundles (x, y). More is (usually) better: monotonicity. A nice mix is better than extremes: convexity (love of variety). Indi!erence curve (IC): all bundles equally liked. IC1 IC2 IC3 x y Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 9 / 41 h YStarteriteManyago Piggai 4S om OS 4M K Pineapples- IS IM.

M · ⑧ Theleue ~ Snappines ·- & Indian L Grve/set S.

· ↳ ⑧.

Properties of Indi!erence Curves Downward sloping: to get more of x, give up some y and remain equally happy. Do not cross: crossing would contradict consistent rankings. Further out ICs represent higher satisfaction. x y Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 10 / 41 - - * higher happines M 600 4 =24 n = 1 - S.

Utility: A Convenient Label for Preferences Utility assigns numbers to ICs (higher number = more preferred). Any increasing relabeling represents the same preferences. We can picture ICs using a simple utility like u = →xy. u=3 u=,3.46 u=4 x y Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 11 / 41 - ① M * &-.

Internal Trading Ratio Figure: Marginal Rate of Substitution Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 12 / 41 - 6 ↳ tel Trading dahi IP - A.

Optimal Choice Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 13 / 41.

Choosing the Best A!ordable Bundle The chosen bundle is where the highest reachable IC touches the budget. At optimum, any move along the budget lowers satisfaction. The Agent equates his MRS between the two goods to the market price ratio. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 14 / 41 MarketTradert-Internal Tradin 0/ I products Nation "Priceratio" "MRS" . D · -Fishert level ofutility possible Disso.

What happens when income changes? Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 15 / 41 · -.

Income Expansion Path (IEP) As income rises (prices fixed), optimal bundles trace the Income Expansion Path. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 16 / 41 Normal Fincome aufteps" E Ademand Inferior & income income Engelbre Lim" his method => ↳demand DafPizza # - Ki.

Inferior Good: Engel Curve Bends Back As income rises, less demand for Pepsi. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 17 / 41 Pepsi IncomOffer ① Income offer curve ↳ ①Engellare T Income InferioMode Pizza - it - - Pedi.

Engel Curve Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 18 / 41 ↳ In enti a -.

What happens when income changes? Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 19 / 41 ↑ Prizza SE. do Cons. of Pigga - - Encore Effect Smellepurchasing/poorer Normal con ofpis - ↑ Inferior A core of pegas TE: SETTE- Prices #Pizza E becomePiss - Normal ↑ Ppiye E Coudde icons officia + githe Inferio.

Price Change ↑ Movement Along Demand When px falls (income fixed), the chosen x rises: downward-sloping demand. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 20 / 41 Normal ↓ Prepsi Told that comme prone ① Same slope a Pepsi The new price ratio SE. demadea ② Guarantees/forms old Iferior utility level Toldest embiguous TE. richer/ puching power increased · Nomal Inferior Apepsi bpens :.

Individual to Market Demand Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 21 / 41.

Deriving the Individual Demand Curve (Graphical Mapping) Each optimal choice at a price gives a point on the demand curve. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 22 / 41 MDemand leave.

Market Demand = Horizontal Sum Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 23 / 41.

Horizontal Sum Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 24 / 41 Green.

Decomposing Price Changes: Income and Substitution E!ects Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 25 / 41 Stophere.

Decomposing a Price Change When px falls, two forces change x: 1 Substitution e!ect: x is relatively cheaper ↑ substitute toward x. 2 Income e!ect: purchasing power rises; for a normal good, buy more x. Graphically we separate them using a “compensated” budget line. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 26 / 41 Slide 26T L.

Substitution and Income E!ect Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 27 / 41.

Interpretation and Example Interpretation: Adjust the relative prices to be the same as the new budget constraint (dashed blue line - parallel to solid red line), holding the indi!erence curve constant to get point B. Moving from point A to B is the Substitution E!ect Then from the dashed blue line, the additional e!ect is a gain in income and so going from point B to C is an income e!ect. Example: Bread became expensive relative to meat. We can decompose the total e!ect into: 1: Substitution E!ect: the relative price of bread comapred to wheat is now higher. Hence, the consumer wants to buy less of it holding his level of indi!erence curve constant. 2: Income E!ect: individual now has less purchasing power. If bread is a normal good, he will spend less on it. If bread is a gi!en good, he will spend more on it. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 28 / 41.

Applications: Do all Demand Curves Slope Downwards Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 29 / 41 2 S.

Gi!en Good Increase in the price of potatoes leads to an increase in quantity demanded of potatoes. Famous example during the Irish famine. Notice how this is because the good is inferior. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 30 / 41 ↑ Potato Inconeffet SE. ↓ Poduta 7 Substiktion TE . Inferior Flat Poore Consume more renconmptio polate of potatoe M.

Applications: Consumption-Leisure Model Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 31 / 41.

When Wages Rise: Two Opposing E!ects in the Consumption–Leisure Model Set-up Total time endowment: T = h + ω (hours of work h and leisure ω). Budget constraint: C = wh + M = w(T ↓ ω) + M, where w is the wage and M is non-labour income. Substitution E!ect (holding utility fixed) A higher wage makes leisure more expensive: opportunity cost of 1hr of leisure is now higher. The individual substitutes away from leisure towards work: less leisure, more labour. Income E!ect (at new wage, higher real income) At the higher wage, for the same hours worked, total income is larger. If leisure is a normal good, higher income increases desired leisure. The individual wants more leisure, less labour. Net E!ect on Labour Supply Substitution e!ect: pushes labour supply up. Income e!ect: pushes labour supply down (if leisure normal). Whether hours worked rise or fall depends on which e!ect is stronger. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 32 / 41 n = T-l D.0 W - > * c + wl = wT + M - = - -.

Consumption-Leisure Model Figure: Optimal Choice between consumption and leisure Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 33 / 41 - - Y " - -.

Income & Substitution E!ects Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 34 / 41 Upward sloppie Care test - supply Downwar Supply care · A c sloping.

Applications: Consumption-Savings Model Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 35 / 41.

Consumption–Saving Decision in a Two-Period Model Set-up Two periods: today (1) and tomorrow (2). Incomes: Y1 today, Y2 tomorrow. Consumption: C1 today, C2 tomorrow. Interest rate on saving/borrowing: r. Intertemporal Budget Constraint NPV:C1 + C2 1+r = Y1 + Y2 1+r If C1 < Y1 you are a saver (lend the di!erence). If C1 > Y1 you are a borrower. Choice Problem Choose (C1, C2) to maximize U(C1, C2) subject to the intertemporal budget line. Graphically: choose a point on the budget line tangent to an indi!erence curve. E!ect of a Higher Interest Rate r Substitution e!ect: future consumption becomes cheaper ↑ save more today (C1 ↔, C2 ↗). Income e!ect: depends on whether you are a saver or borrower. If saver: higher r makes you richer → can a!ord more of both C1 and C2. If borrower: higher r makes you poorer → can a!ord less of both C1 and C2. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 36 / 41 = u like time Netrwe - I choices save - - -.

= IEI Total or 2 that him &i.

Income and Substitution E!ects Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 37 / 41.

Quick Practice (Think–Pair–Share) 1 Draw a budget with M = 100, px = 10, py = 5. Mark intercepts and slope. 2 Sketch ICs for a consumer who likes variety. Find a likely best bundle. 3 Show the e!ect of px falling to 7 and decompose into substitution and income e!ects. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 38 / 41.

Concept Check: Normal vs Inferior Suppose income rises. Show on a graph how the optimal x changes if: x is normal: IEP and Engel curve slope upward. x is inferior: after some income level, Engel bends backward. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 39 / 41.

Key Takeaways Budgets define what’s a!ordable; preferences rank bundles. The best a!ordable bundle occurs where the highest IC touches the budget. Varying the price of x traces the demand curve for x. Varying income (prices fixed) traces the Engel curve for x. Price changes split into substitution and income e!ects. Normal vs inferior goods di!er in the sign of the income e!ect. Ahmed Tohamy (American University in Cairo) Consumer Theory (A Graphical Treatment) November 14, 2025 40 / 41.