consumer demand theory (1)

7/31/2019 Consumer Demand Theory (1)

1/58

Consumer Demand Theory


2/58

3 Basic Assumptions

Each consumer has complete information on

all matters pertaining to consumer decisions

The consumer knows the range of goods available

in the market and the capacity of the good to

satisfy human wants

The exact price of each good is known.

The consumer knows his income during theplanning period


3/58

3 Basic Assumptions

Given the 3 assumptions, each consumer tries

to maximize utility/satisfaction/happiness

given a limited income.

Utility the satisfaction a consumer derives

from whatever good/service he/she

consumes. This is the basis of choice.


4/58

Two Approaches

Marginal Utility Approach

Indifference Curve Approach


5/58


Assumption: Utility is measurable andquantifiable

Util a measure of pleasure or satisfaction

Total Utility (TU) Total utility is the total utilitya consumer derives from the consumption ofall of the units of a good or a combination of

goods over a given consumption period,ceteris paribus.

Total utility = Sum of marginal utilities


6/58


Marginal utility is the utility a consumer

derives from the last unit of a consumer good

she or he consumes (during a given

consumption period), ceteris paribus.

- the slope of total utility curve

Q

TUMU


7/58

Hall & Leiberman; Economics:Principles And Applications,

2004

7

Total Utility and Marginal Utility

No of cones Total utility Marginal Utility

0 0 utils

1 30 utils 30 utils

2 50 utils 20 utils

3 60 utils 10 utils

4 65 utils 5 utils

5 68 utils 3 utils

6 69 utils 1 utils


8/58

Hall & Leiberman; Economics:Principles And Applications,

2004

8

Total And Marginal Utility

Total Utility

Marginal Utility

Utils 302010

Ice Cream Cones per Week1 2 3 4 5 6

Utils

605040

70

30

2010

Ice Cream Cones per Week1 2 3 4 5 6

1. The change in total utilityfromone more ice cream cone . . .

2. is called the marginalutility

of an additional cone.

3. Marginal utility falls

as more cones areconsumed.


9/58

Total and Marginal Utility for Ice Cream

Q ($) TU ($) MU

0 0

1 40 40

2 85 45

3 120 35

4 140 20

5 150 10

6 157 7

7 160 38 160 0

9 155 -5

10 145 -10

145


10/58

Total Utility

0

50

100

150

200

1 2 3 4 5 6 7 8 9 10 11

($) MU

-20

-10

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 1 11

Q ($) TU ($) MU

0 0

1 40 40

2 85 45

3 120 35

4 140 205 150 10

6 157 7

7 160 3

8 160 0

9 155 -5

10 145 -10

145


11/58

Total Utility and Marginal Utility

Saturation point a point where increase in

consumption of unit of a good, total utility did

not increase.

In the schedule it is between 7 and 8


12/58

The Law of Diminishing Marginal Utility

Over a given consumption period, as more and more of

a good is consumed by a consumer, beyond a certain

point, the marginal utility of additional units begins tofall.


13/58

CONSUMER SURPLUS

= the gap between the total utility of a good and itstotal market value

The surplus arises because we receive more

than we pay for, it is rooted in the law ofdiminishing marginal utility

we pay for each unit what the last unit is worthbut by the law of diminishing marginal utility the

earlier units are worth more to us than the lastthus, we enjoy a surplus of utility on each ofthese earlier units


14/58

Consumer Surplus

The difference between what a consumer is

willing to pay for an addition unit of a good

and the market price that he/she actually pays

is referred to as consumer surplus.

The area between the demand curve and the

price (line) measures the total consumer

surplus.


15/58

Consumer Surplus

Price

D

Qx

0

P


16/58

Diamond/Water Paradox

The things with the greatest value use

frequently have little or no value in exchange,

and

The things with the greatest value in exchange

frequently have little or no value in use.


17/58


Why is water which is essential to life so cheap

while diamonds which are not essential to life

so expensive?

Water has a great use value but low exchange

value because supply is abundant.

Even at a price of zero we do not consume an

infinite amount of water. We consume up to

the point where MU drops to zero.


18/58


Diamond low use value but high exchange

value.

low supply MU tends to be very high

willing to pay a high price

Price of the good is determined by the MU of

the last unit of a good not by the TU.


19/58

Indifference Curve Analysis

1881 Francis Y. Edgeworth, British

Economist, introduced the IC technique

1906 IC technique was adopted by an Italian

Economist, Vilfredo Pareto

1930s 2 British Economists: John R. Hicks

and Roy George Douglas Allen popularized the

IC technique


20/58

Assumptions on the nature of

consumer preferences

Preferences are complete.

The consumer is able to set up a preference

ranking of the combinations available.

X > Y X is preferred over Y

Y>X Y is preferred over X

X Y indifferent between X and Y


21/58

Assumptions on the nature of

consumer preferences

Preferences are transitive.

The consumer makes choices that are consistent

with each other.

A > B, B>C therefore, A>C

More is better.

The consumer prefers more of any goods or

services to less of it because more goods orservices give her a higher level of satisfaction


22/58

THE THEORY OF CONSUMERCHOICE

22

Preferences: What the Consumer Wants

Quantity

of Fish

Quantity

of Mangos

Indifference curve:

shows consumptionbundles that give the

consumer the same

level of satisfaction

A consumption bundle is aparticular combination of the

goods, e.g., 40 fish & 300

mangos.

A, B, and all other bundleson I1 makes a person

equally happy the person

is indifferentbetween them.

I1

Indifference curve

B

A


23/58


23

Four Properties of Indifference Curves

Quantity

of Fish

Quantity

of Mangos

If the quantity offish is reduced,

the quantity of

mangos must be

increased to keep theperson equally happy.

A

Indifference curve

I1

1. Indifference curvesare downward-

sloping.

B


24/58


24


Quantity

of Fish

Quantity

of Mangos

He prefers every bundleon I2 (like C)

to every bundle on I1

(like A).

Indifference curves

I1

I2

I0

D

2. Higher indifferencecurves are preferred

to lower ones.

He prefers every bundleon I1 (like A)

to every bundle on I0

(like D).

C

A


25/58


25


Quantity

of Fish

Quantity

of Mangos

If it did, it violates the

transitivity assumption.

A B both are onI1A C - both are on I4

Therefore, B C not true

because C > A

Indifference curves

I1

3. Indifference curvescannot cross.

B

C

I4

A


26/58


26


Quantity

of Fish

Quantity

of Mangos

He is willing to give up

more mangos for a fish ifhe has few fish (A) than

if he has many (B).

4. Indifference curvesare bowed inward.

I1

1

1

6

2

A

B


27/58


27

The Marginal Rate of Substitution

Quantity

of Fish

Quantity

of Mangos

MRS is the amount of

mangos he would

substitute for another

fish. I1

1

1

6

2

A

B

Marginal rate of

substitution (MRS):

the rate at which a consumer

is willing to trade one good for

another.

MRS = is the

negative of theslope of

indifference curve

MRS =

MRS =

MRS falls as you move down

along an indifference curve.


28/58


28

One Extreme Case: Perfect SubstitutesPerfect substitutes: two goods with straight-

line indifference curves,constant MRS

Example: nickels & dimes

Consumer is always willing to tradetwo nickels for one dime.


29/58


29

Another Extreme Case: Perfect Complements

Perfect complements: two goods with

right-angle indifference curvesExample: Left shoes, right shoes

{7 left shoes, 5 right shoes}

is just as good as

{5 left shoes, 5 right shoes}


30/58

Less Extreme Cases:

Close Substitutes and Close Complements

Quantity

of Coke

Quantity

of Pepsi

Indifference

curves for close

substitutes are

not very bowed

Quantity

of hot dogs

Quantity

of hot dog

buns

Indifference

curves for

close

complements

are very bowed


31/58


31

The Budget Constraint:

What the Consumer Can Afford

Example:Hurley divides his income between two goods:

fish and mangos.

Budget constraint: the limit on the consumption

bundles that a consumer can afford

Shift in the budget constraint:

1. change in income

2. change in the price/s of the goods


32/58

Hurleys income: $1200Prices: PF = $4 per fish, PM = $1 per mango

A. If Hurley spends all his income on fish,

how many fish does he buy?

B. If Hurley spends all his income on mangos,

how many mangos does he buy?

C. If Hurley buys 100 fish, how many mangos can he

buy?

D. Plot each of the bundles from parts AC on a

graph that measures fish on the horizontal axis and

mangos on the vertical, connect the dots.

A C T I V E L E A R N I N G 1

Budget Constraint

32


33/58

A. $1200/$4

= 300fish

B. $1200/$1= 1200

mangos

C. 100fish cost

$400,$800 left

buys 800

mangos


Answers

Quantity

of Fish

Quantity of

Mangos

A

B

C

D. Hurleys budget

constraint shows thebundles he can

afford.


34/58


34

The Slope of the Budget Constraint

Quantity

of Fish

Quantity of

Mangos

D

From C to D,

rise =

200 mangos

run =

+50 fishSlope = 4

Hurley must

give up

4 mangos

to get one fish.

C


35/58


35

The Slope of the Budget Constraint

The slope of the budget constraint equals

the rate at which Hurley

can trade mangos for fish

the opportunity cost of fish in terms of mangos

the relative price of fish:$

$

price of fish 44 mangos per fish

price of mangos 1


36/58

Show what happens to Hurleys budget constraint if:

A. His income falls to $800.

B. The price of mangos rises to

PM = $2 per mango


Budget constraint, continued.

36


37/58

Now,Hurley

can buy

$800/$4

= 200 fishor

$800/$1

= 800 mangos

or any

combination in

between.


Answers, part A

Quantity

of Fish

Quantity of

Mangos

A fall in income

shifts the budgetconstraint down.


38/58

Hurley

can still buy

300 fish.

But now he

can only buy$1200/$2 =

600 mangos.

Notice:

slope is smaller,relative price of

fish is now only 2

mangos.


Answers, part B

Quantity

of Fish

Quantity of

Mangos

An increase in the

price of one goodpivots the budget

constraint inward.


39/58


39

Optimization: What the Consumer Chooses

Quantity

of Fish

Quantity

of Mangos

1200

600

300150

A is the optimum:

the point on thebudget constraint

that touches the

highest possible

indifference curve.

Hurley prefers B to A,

but he cannot afford B. A

C

D

Hurley can afford C

and D,

but A is on a higher

indifference curve.

B

The optimum

is the bundleHurley most

prefers out of all

the bundles he

can afford.


40/58


40

Optimization: What the Consumer Chooses

Quantity

of Fish

Quantity

of Mangos

1200

600

300150

At the optimum,

slope of the

indifference curve

equals

slope of the budget

constraint:

MRS = PF/PM A

marginalvalue of fish

(in terms of

mangos)

price of fish

(in terms of

mangos)


41/58

THE THEORY OF CONSUMERCHOICE 41

The Effects of an Increase in Income

Quantity

of Fish

Quantity

of Mangos

An increase in

income shifts the

budget constraint

outward.

If both goods are

normal, Hurley

buys more of each.

A

B


42/58

An increase in income increases the quantitydemanded ofnormal goods and reduces the

quantity demanded ofinferior goods.

Suppose fish is a normal goodbut mangos are an inferior good.

Use a diagram to show the effects of

an increase in income on Hurleys optimalbundle of fish and mangos.


Inferior vs. normal goods

42


43/58


Answers

43

Quantity

of Fish

Quantity

of Mangos

If mangos are

inferior, the new

optimum will contain

fewer mangos.

AB


44/58


500

350

The Effects of a Price Change

Quantity

of Fish

Quantity

of Mangos

1200

600

300150 600

initial

optimum

newoptimum

Initially,

PF = $4

PM = $1

PF falls to $2budget constraint

rotates outward,

Hurley buys

more fish andfewer mangos.


45/58


A fall in the price of fish has two effects on

Hurleys optimal consumption of both goods. Income effect

A fall in PFboosts the purchasing power of Hurleys

income, allows him to buy more mangos and more fish.

Substitution effect

A fall in PF makes mangos more expensive relative to fish,

causes Hurley to buy fewer mangos & more fish.

Notice: The net effect on mangos is ambiguous.

The Income and Substitution Effects


46/58


The Income and Substitution Effects

Initial

optimum at A.

PF falls.

Substitution effect:

from A to B,buy more fish and

fewer mangos.

Income effect:

from B to C,buy more of both

goods. Quantityof Fish

Quantity

of Mangos

A

B

C

In this example,

the net effect on

mangos is

negative.


47/58

Do you think the substitution effect would bebigger for substitutes or complements?

Draw an indifference curve for Coke and Pepsi, and,

on a separate graph, one for hot dogs and hot dogbuns.

On each graph, show the effects of a relative price

change (keeping the consumer on the initialindifference curve).


The substitution effect in two cases

47


48/58

But the substitution effect is bigger for substitutesthan complements.


Answers

Quantity

of Coke

Quantity

of Pepsi

In both graphs, the relative price changes bythe same amount.

Quantity

of hot dogs

Quantity of

hot dog buns

A

B

A B

Deriving Hurleys Demand Curve for Fish


49/58

$2 DFish

Deriving Hurley s Demand Curve for Fish

350 Quantity

of Fish

Quantity

of Mangos

Quantity

of Fish

Price of

Fish

150

AB

150

$4A

350

B

49

A: When PF = $4, Hurley demands 150 fish.B: When PF = $2, Hurley demands 350 fish.


50/58


Application 1: Giffen Goods

Do all goods obey the Law of Demand?

Suppose the goods are potatoes and meat,

and potatoes are an inferior good.

If price of potatoes rises, substitution effect: buy less potatoes

income effect: buy more potatoes

If income effect > substitution effect,then potatoes are a Giffen good, a good for which an

increase in price raises the quantity demanded.

Application 1:


51/58


Application 1:

Giffen Goods

A li ti 2 W d L b S l


52/58


Application 2: Wages and Labor Supply

Budget constraint

Shows a persons tradeoff between consumption andleisure.

Depends on how much time she has to divide between

leisure and working.

The relative price of an hour of leisure is the amount of

consumption she could buy with an hours wages.

Indifference curve

Shows bundles of consumption and leisure

that give her the same level of satisfaction.



53/58



At the optimum,

the MRS betweenleisure and

consumption equals

the wage.



54/58



An increase in the wage has two effectson the optimal quantity of labor supplied.

Substitution effect(SE): A higher wage makes leisure

more expensive relative to consumption.The person chooses less leisure,i.e., increases quantity of labor supplied.

Income effect (IE): With a higher wage,

she can afford more of both goods.She chooses more leisure,i.e., reduces quantity of labor supplied.



55/58

THE THEORY OF CONSUMER

CHOICE 55


For this person, SE

> IE

So her labor supply

increases with the wage



56/58


CHOICE 56


For this person, SE

< IE

So his labor supply falls

when the wage rises


57/58


CHOICE 57

Could This Happen in the Real World???Cases where the income effect on labor supply is very

strong:

Over last 100 years, technological progress has

increased labor demand and real wages.

The average workweek fell from 6 to 5 days. When a person wins the lottery or receives an

inheritance, his wage is unchanged hence no

substitution effect.

But such persons are more likely to work fewer

hours, indicating a strong income effect.

CONCLUSION:


58/58

CONCLUSION:

Do People Really Think This Way?

People do not make spending decisionsby writing down their budget constraints and

indifference curves.

Yet, they try to make the choices that maximize their

satisfaction given their limited resources. The theory is only intended as a metaphor for how

consumers make decisions.

It explains consumer behavior fairly well in many

situations and provides the basis for more advanced

economic analysis.

consumer demand theory (1)

Documents