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Lesson summary: Demand and the determinants of demand. Next lesson. Current timeTotal duration Google Classroom Facebook Twitter. Video transcript What I want to do in this video is think about the demand curve for two different products.
The line segment that connects two points on the indifference curve lies to the northeast of the indifference curve, which means that the line segment involves strictly more consumption of both goods than some points on the indifference curve. In other words, it is preferred to the indifference curve. Convex preferences mean that a consumer prefers a mix to any two equally valuable extremes. Thus, if the consumer likes black coffee and also likes drinking milk, then the consumer prefers some of each—not necessarily mixed—to only drinking coffee or only drinking milk.
If you like drinking 60 cups of coffee and no milk per month as much as you like drinking 30 glasses of milk and no coffee, convex preferences entail preferring 30 cups of coffee and 15 glasses of milk to either extreme.
How does a consumer choose which bundle to select? If Y is a good, this constraint will be satisfied with equality, and all of the money will be spent. The first-order condition for this problem, maximizing it over x , has.
This can be rearranged to obtain the marginal rate of substitution MRS :. The marginal rate of substitution MRS The amount extra of one good needed to make up for a decrease in another good, staying on an indifference curve. The first-order condition requires that the slope of the indifference curve equals the slope of the budget line; that is, there is a tangency between the indifference curve and the budget line.
Three indifference curves are drawn, two of which intersect the budget line but are not tangent. At this point, further increases in utility are not feasible, because there is no intersection between the set of bundles that produce a strictly higher utility and the budget set. Thus, the large black dot is the bundle that produces the highest utility for the consumer. Second, the equation that characterizes the optimum,.
There are three ways that it can fail. First, the utility might not be differentiable. This is exactly the kind of failure that is ruled out by convex preferences. This is a fundamental problem because, in fact, there are many goods that we do buy zero of, so zeros for some goods are not uncommon solutions to the problem of maximizing utility.
We will take this problem up in a separate section, but we already have a major tool to deal with it: convex preferences. Since utility is zero if either of the goods is zero, we see that a consumer with Cobb-Douglas preferences will always buy some of each good. The marginal rate of substitution for Cobb-Douglas utility is. This yields. The Cobb-Douglas utility results in constant expenditure shares. This makes the Cobb-Douglas utility very useful for computing examples and homework exercises.
When two goods are perfect complements, they are consumed proportionately. In this way, perfect complements boil down to a single good problem. If the only two goods available in the world were pizza and beer, it is likely that satiation The point at which increased consumption does not increase utility. How many pizzas can you eat per month? How much beer can you drink?
What does satiation mean for isoquants? It means there is a point that maximizes utility, which economists call a bliss point A point that maximizes utility. An example is illustrated in Figure Near the origin, the isoquants behave as before.
However, as one gets full of pizza and beer, a point of maximum value is reached, illustrated by a large black dot. What does satiation mean for the theory? With a bliss point within reach, consumption will stop at the bliss point. A feasible bliss point entails having a zero value of money. There may be people with a zero value of money, but even very wealthy people, who reach satiation in goods that they personally consume, often like to do other things with the wealth and appear not to have reached satiation overall.
It would be a simpler world if an increase in the price of a good always entailed buying less of it. In this case, the quantity y of Y demanded rises.
At first glance, this increase in the consumption of a good in response to a price increase sounds implausible, but there are examples where it makes sense. The primary example is leisure. As wages rise, the cost of leisure forgone wages rises. But as people feel wealthier, they choose to work fewer hours. When the price of potatoes rises, they can no longer afford meat and buy even more potatoes than before.
Thus, the logical starting point on substitution—what happens to the demand for a good when the price of that good increases—does not lead to a useful theory. As a result, economists have devised an alternative approach based on the following logic. An increase in the price of a good is really a composition of two effects: an increase in the relative price of the good and a decrease in the purchasing power of money.
As a result, it is useful to examine these two effects separately. The substitution effect The effect on consumption of a change in the relative price, with a sufficient change in income to keep the consumer on the same utility isoquant.
Some authors instead change the income enough to make the old bundle affordable. This approach has the virtue of being readily computed, but the disadvantage is that the substitution effect winds up increasing the utility of the consumer.
Overall the present approach is more economical for most purposes. The income effect changes only income. To graphically illustrate the substitution effect, consider Figure The new budget line is illustrated with a heavy, dashed line.
To find the substitution effect, increase income from the dashed line until the original isoquant is reached. Increases in income shift the budget line out in a fashion parallel to the original. Description: The level of productivity in an economy falls significantly during a d.
It is always measured in percentage terms. Description: With the consumption behavior being related, the change in the price of a related good leads to a change in the demand of another good. Related goods are of two kinds, i. Description: Apart from Cash Reserve Ratio CRR , banks have to maintain a stipulated proportion of their net demand and time liabilities in the form of liquid assets like cash, gold and unencumbered securities.
Treasury bills, dated securities issued under market borrowing programme. In the world of finance, comparison of economic data is of immense importance in order to ascertain the growth and performance of a compan.
Description: Institutional investment is defined to be the investment done by institutions or organizations such as banks, insurance companies, mutual fund houses, etc in the financial or real assets of a country. Simply state. Marginal standing facility MSF is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely.
Description: Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short. The MSF rate is pegged basis points or a percentage. Description: If the prices of goods and services do not include the cost of negative externalities or the cost of harmful effects they have on the environment, people might misuse them and use them in large quantities without thinking about their ill effects on the env.
It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. Asset turnover ratio can be different fro.
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What Is an Inferior Good? Understanding Inferior Goods. Inferior Good Examples. Consumer Behavior. Inferior Goods and Giffen Goods. Normal Goods and Luxury Goods. Inferior Goods FAQs. Key Takeaways An inferior good is one whose demand drops when people's incomes rise. When incomes are low or the economy contracts, inferior goods become a more affordable substitute for a more expensive good.
Inferior goods are the opposite of normal goods, whose demand increases even when incomes increase. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Income elasticity of demand measures the relationship between a change in the quantity demanded for a particular good and a change in real income.
Income Effect Definition Income effect is the change in demand for a good or service caused by a change in a consumer's purchasing power due to a change in real income. What Determines a Normal Good A normal good is a good that experiences an increase in its demand due to a rise in consumers' income. Normal goods include food staples and clothing. What Is Luxury Item? A luxury item is not necessary for living but is deemed as highly desirable within a culture or society. Discover more about the term "luxury item" here.
Lipstick Effect Definition The lipstick effect is a theory that spending on small indulgences such as premium lipstick increases during periods of recession.
Demand Theory Definition Demand theory is a principle relating to the relationship between consumer demand for goods and services and their prices. Partner Links. Related Articles. Microeconomics Income Effect vs.
Substitution Effect: What's the Difference?
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