1

Economics of Demand

or

Theory of Consumer

Behavior

Chapter 2

Chapter 5 p. 119-120

Topics Topics

• Where are we going?

• Utility Theory

– Marginal utility

• Indifference curves

• Budget constraint

• Consumer equilibrium - The law of demand

• Change in quantity demanded vs. change in demand

• Shifters of demand

• Consumer surplus

Market Market

Q*

Quantity

Supply

Demand

Price

P*

2

What is Utility? What is Utility?

• Jeremy Bentham Introduction to the

Principles of Morals and Legislation 1789

– “Nature has placed mankind under the

governance of two sovereign masters, pain and

pleasure” … mankind “only object is to seek

pleasure and shun pain.”

• Utils

Who is Jeremy Bentham? Who is Jeremy Bentham?

• Jeremy Bentham

1748 -1832

• Philosopher

• Corresponded with

Adam Smith

• Auto-icon

Visit Jeremy at

http://www.ucl.ac.uk/museums/jeremy-bentham/visit

William Stanley Jevons 1835-1882 William Stanley Jevons 1835-1882

• Studied chemistry, mathematics, and

logic in 1850-51 left without a degree

• Returned to college in 1859 earned a

MA degree which included logic, moral

philosophy, political philosophy, history

of philosophy, and political economy

• Drowned while swimming

• “Value depends entirely upon utility” – not

costs as previous thought

3

Dinner! Dinner!

• Who would like a nice premium grill rib eye steak?

Corn on the Cob? How much are you willing to

pay?

Marginal Utility Marginal Utility

• Change in utility derived from a change in consumption of a particular good holding other goods constant

• Law of Diminishing Marginal Utility - as consumption per unit of time increases, marginal utility decreases

• Examples

– Bentham - income

– Jevons – water

– Steak

Indifference / Isoutility Curves Indifference / Isoutility Curves

1 2 3 4 5 6 7 8

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

4

Indifference Curves Indifference Curves

Which bundle would you

prefer more…bundle M or

bundle B?

Which bundle would you

prefer more…bundle M or

bundle B? M

B

1 2 3 4 5 6 7 8

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

The answer is that this we

would be indifferent

because they give us the

same utility. The ultimate

choice will depend on the

prices of these two

products.

The answer is that this we

would be indifferent

because they give us the

same utility. The ultimate

choice will depend on the

prices of these two

products.

Indifference Curves Indifference Curves

1 2 3 4 5 6 7 8

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

Increasing Utility

Preference

Directions

B

A

Indifference Curves Indifference Curves

1 2 3 4 5 6 7 8

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

Which bundle would you

prefer more…bundle C or

bundle N?

Which bundle would you

prefer more…bundle C or

bundle N?

C N We would prefer bundle N

over bundle C because it

gives us more utility or

satisfaction. The question

is whether we can afford

to buy bundle N!

We would prefer bundle N

over bundle C because it

gives us more utility or

satisfaction. The question

is whether we can afford

to buy bundle N!

5

Characteristics Indifference Curves Characteristics Indifference Curves

• Slopes – Negative

• Non-intersection – Do not cross

• Everywhere dense – Can always compare consumption bundles

• Convex to origin – Can not be proved – common sense

Characteristics Indifference Curves Characteristics Indifference Curves

• Slopes – Negative

• Non-intersection – Do not cross

• Everywhere dense – Can always compare consumption bundles

• Convex to origin – Can not be proved – empirically

observe

A B

C

Empirically observe

C and not D

D

Convex to Origin Convex to Origin

M

Food

En

terta

inm

ent

6

Marginal Rate of Substitution Marginal Rate of Substitution

• The rate at which the consumer is willing to substitute one good for another and maintain a constant utility level

• MRS of corn for steak with utility constant

• Notice - rise over run = the slope for a specific segment for a nonlinear curves

corn

steak

Marginal Rate of Substitution Marginal Rate of Substitution

• MRScorn for steak

going from 2 to 3

ears

1 2 3 4 5 6 7 8

1

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

-1

This means the consumer

is willing to give up 1 steak

in exchange for one

additional ear of corn!

This means the consumer

is willing to give up 1 steak

in exchange for one

additional ear of corn!

11

1

corn

steak _

Marginal Rate of Substitution Marginal Rate of Substitution

• MRSsteak for corn going

from 2 to 3 steaks

1 2 3 4 5 6 7 8

-2

Corn ears consumed per week

Ste

ak

s co

nsu

med

per

week

1 2

3

4

5

6

7

8

1

5.02-

1

corn

steak-

This means the consumer

is willing to give up 2 ears

of corn for one additional

steak or 1 ear for ½ steak!

This means the consumer

is willing to give up 2 ears

of corn for one additional

steak or 1 ear for ½ steak!

7

Marginal Rate of Substitution Marginal Rate of Substitution

• Why? – Utility must be constant

– What you give up with one, you must gain with the other!

steak

corn

MU

MU

corn

steakMRS

Budget Constraint Budget Constraint

• Represents the amount of income available for spending on the consumption bundles

• Example corn / steak weekly budget

Psteak x Qsteak + Pcorn x Qcorn Budget

where Psteak and Pcorn represent the price of steak and corn while Qsteak and

Qcorn represent the quantities you purchase during the week.

• Omaha Steaks

– 4 (18 oz.) Private Reserve Bone-in Frenched

Ribeyes $178.00 -- round to $40 / pound

– For ease use pounds of steak

• New York Style Deli

– Own Home Grown Corn on the Cob. Seasonal

Item. Picked fresh daily

– Buy 12 ears delivered to your door $22.50

– For ease let’s use 12 ears and round to $20

FYI! FYI!

8

Budget Constraint – Graph

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Apply all income to steaks

$200 / 40 = 5 pounds

Apply all income to corn

$200 / 20 = 10 dozen ears Budget Constraint

$40 x steak + $20 x corn = $200

Steak Price Decreases by 1/2 Steak Price Decreases by 1/2

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

9 1

0

Steaks price decreases by 1/2

$200 / 20 = 10 pounds

Apply all income to corn

$200 / 20 = 10 dozen

ears

Original price budget

constraint

After price change budget

constraint

Steak Price Increases by 2 Steak Price Increases by 2

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

9 1

0

Original price budget

constraint

Steak price decreases by

1/2 budget constraint

Steak price doubles budget

constraint

9

Corn Price Changes Corn Price Changes

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

9 1

0

Original price budget

constraint

Corn price doubles

Corn price decreases by 1/2

Income Decreases by 1/2 Income Decreases by 1/2

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

All income applied to steaks

$100 / 40 = 2.5 pounds

Apply all income to corn

$100 / 20 = 5 dozen

ears

Original Budget

Line

Budget Line

at ½ income

Income Changes - Know Income Changes - Know

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Shifts

- Direction?

- How?

See book / homework

10

• Definition of economics

“…a social science that deals with how consumers,

producers, and societies choose among the alternative uses

of scarce resources in the process of producing, exchanging,

and consuming goods and services”

• Question

How can we combine indifference curves and budget

constraints to examine consumer choice?

Economic - Choices Economic - Choices

• Two goods steak and corn

• Prices - steak $40 / lb and corn $20 / dozen ears

• $200 per week to spend

• Objective

Allocate your limited budget to steak and corn such that you will

maximize your utility

• Solution

Combine budget constraint and indifference curves on one graph. Point

of tangency will be maximum for a given budget and prices.

• In a nut shell – how much steak and how much corn do I buy!

Problem Problem

Budget Constraint – Graph

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Apply all income to steaks

$200 / 40 = 5 pounds

Apply all income to corn

$200 / 20 = 10 dozen ears Budget Constraint

$40 x steak + $20 x corn = $200

11

Add Indifference Curves

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Consumption bundle

6 corn and 1 steak

= 6*20 + 1 *40 = $160

Consumption bundle

1 corn and 4.5 steak

= 1*20 + 4.5*40 = $200

Can We Do Better?

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Consumption bundle

7 corn and 3.5 steak

= 7*20 + 3.5 * 40 = 280

Increasing Utility

Conclude So Far

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1 2

3

4

5

6

7

8

Indifference curves lying below the

budget constraint do not spend all

the budget except where intersect

Indifference curves and points lying

above the budget constraint exceed

our budget

Budget Constraint

12

Can We Do Better?

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8

Consumption bundle

5 corn and 2.5 steak

= 5*20 + 2.5 * 40 = 200

Budget is all spent

Question – can we increase utility?

Objective - Maximize Utility

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8

Indifference Curve – below budget constraint

Can increase utility by moving outward

Not Optimal

Indifference Curves and

points above the budget

Constraint exceeds your

budget - not feasible

Point Indifference Curve is Tangent

to Budget Constraint

Feasible – spends all budget

Maximizes Utility – highest curve obtainable

Tangent Point

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8

Slope of budget constraint = slope of indifference curve

slope of indifference curve =

steak

corn

MU

MU

corn

steakMRS

What is slope of

budget constraint?

13

Slope Budget Constraint

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8

Using x and y intercept points to calculate slope

corn = 0, steak = 5 and corn = 10 and steak = 0

Slope = rise / run = (5-0)/(0-10) = -0.5

Recall how we obtained these points

Income / price of steak = 5 and

Income / price of corn = 10

Steak

Corn

Corn

steak

Corn

steak

P

P

P

I

P

I

)P

I0(

)0P

I(

• Slope of indifference curve = slope of budget constraint

• Slope of indifference curve = MRS = - MUcorn / MUsteak

• Slope of budget constraint = -Pcorn / Psteak

• Therefore,

Tangency Conditions

steak

steak

corn

corn

steak

corn

steak

corn

P

MU

P

MU

P

P

MU

MUMRS

• Point where utility is maximized subject to the budget constraint occurs at

MUCorn MUsteak

Pcorn Psteak

• In other words, the marginal utility derived from the last dollar spent on each good is identical. This can be expanded to include all goods and services purchased by the consumer.

Consumer Equilibrium

=

14

Question What point maximizes utility?

A, B, C, or D

Why?

Question What point maximizes utility?

A, B, C, or D

Why?

Another Example - Consumer Equilibrium Another Example - Consumer Equilibrium

Points B and D

exceed the budget

Points B and D

exceed the budget

Consumer Equilibrium Consumer Equilibrium

Point C does

not maximize

utility…

Point C does

not maximize

utility…

Consumer Equilibrium Consumer Equilibrium

15

Point A maximizes

utility…

Point A maximizes

utility…

Consumer Equilibrium Consumer Equilibrium

Corn Price Change Effect

1 2 3 4 5 6 7 8 9 10 11

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8

Original Price = $20 / doz.

Consumption bundle

2.5 steak and

5 dozen ears of corn

What if price decreases to $15?

What happens to budget constraint?

Corn Price Now $15 / doz

New x-intercept

Same Why

New x-intercept

= 200 / 15= 13.2

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4

5

6

7

8 9

1

0 1

1

New equilibrium

= 2.75 steak and 6 corn

Why an increase in corn

and increase in steak?

16

Income / Substitution Effects

1 2 3 4 5 6 7 8 9 10 11 12 13

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

1

2

3

4

5

6

• Substitution Effect – relative prices

MUCorn / Pcorn = MUsteak / Psteak

• Real Income Effect – market opportunity set

Corn Price Now $50 / doz

New y-intercept same

Why?

New x-intercept

= 200 / 50 = 4

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4 5

6

7

8 9

1

0 1

1

New equilibrium

= 3.125 steak and 1.5 corn

Why an decrease in corn

and increase in steak?

Price Consumption Curve

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Dozen corn ears consumed per week

Ste

ak

s (l

bs)

co

nsu

med

per

week

1

2

3

4 5

6

7

8 9

1

0 1

1

• Indicates the response of the rational consumer

to changes in price of corn alone,

income and price of steak being held fixed.

• Arrow indicates increase utility!

• Negative slope – at lower price consumes

more corn but less steak as price of corn drops

• Positive slope – at higher price consumes more of

both as corn price drops

17

Individual Demand Curve - Corn

Demand Curve for Corn

0

10

20

30

40

50

60

0 2 4 6 8

Quantity

dozen ears of corn

Pri

ce

do

llar

per

do

zen

ears̀

Demand Schedule

Price Quantity

50 1.5

20 5

15 6

Person 1 Person 2 Market

Price Quantity Quantity Quantity

50 1.5 3 4.5

20 5 6 11

15 6 7 13

Market Demand Curve - Corn

The market demand curve is the horizontal

summation of the demand schedules

for all the consumers in the market.

At a price of $50, Person 1 would buy 1.5 dozen

ears of corn while Person 2 would buy 3.

Therefore, the market demand is equal to 4.5

dozen ears at a price of $50.

The market demand curve is the horizontal

summation of the demand schedules

for all the consumers in the market.

At a price of $50, Person 1 would buy 1.5 dozen

ears of corn while Person 2 would buy 3.

Therefore, the market demand is equal to 4.5

dozen ears at a price of $50.

+ =

Market Demand Curve - Corn

Person 1

0

10

20

30

40

50

60

0 5 10

Dozen ears

of corn

Pri

ce

/ p

ou

nd

`

Person 2

0

10

20

30

40

50

60

0 5 10

Dozen ears

of corn

Pri

ce

/ p

ou

nd

`

Market

0

10

20

30

40

50

60

0 5 10 15

Dozen ears

of corn

Pri

ce

/ p

ou

nd

`

18

Demand Curve Jargon

• Specific terms to distinguish between

movement along a demand curve and a shift

in a demand curve

• Change in the quantity demanded is a

movement along a demand curve - Cause

• Change in demand is a shift in the demand

curve - Causes

Movement Examples - Know

• Movement A to B is ?

• Movement A to C is ?

• Movement B to C is ?

• Movement C to A is ?

A B

C

Quantity

Pri

ce

Consumer Surplus

• The demand curve reveals the maximum willingness of

consumers to pay for a corresponding quantity

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

What is the consumer’s

WTP for the 2nd unit?

What surplus does the

consumer receive if

price = $ 6?

19

Consumer Surplus

• What is WTP for the 4th unit? Surplus = ?

• What is WTP for the 6th unit? 8th ? 10th? Surplus = ?

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

What is surplus

at the 14th unit?

Why?

Consumer Surplus

• Sum of surplus at each quantity

• Triangle – below the demand curve and above the price line

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

Consumer Surplus Change

• Triangle area given by points ABC =

consumer surplus at a price = $ 6

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

A

B C

20

Consumer Surplus Change

• What is the change in consumer surplus if price increases to $8?

• Consumer surplus is now triangle ADE lose of area DEBC

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

A

B C

E D

Consumer Surplus

• Calculating the area = (height x width)/2

• = {(11-6) x (10-0)}/2 = 25 utils

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22 24

Quantity

Pri

ce

`

Individual Demand Curve - Steak

• Be sure to be able to do the mechanics for

steaks

– Consumer equilibrium

– Change in steak prices holding income and

price fixed – substitution / income effect

– Price consumption path

– Individual demand curve

21

0

1

2

3

4

5

6

7

8

9

10

11

0 5 10 15 20 25

Dozen Ears of Corn

Po

un

ds

of

Ste

ak

`

• Original Consumer Equilibrium

5 corn and 2.5 steak

• Income doubles

What happens?

Income Change Effect

0

1

2

3

4

5

6

7

8

9

10

11

0 5 10 15 20 25

Dozen Ears of Corn

Po

un

ds

of

Ste

ak

~

New y-intercept = 400 / 40 = 10

Income Doubles

New x-intercept

= 400 / 20 =20

New consumer equilibrium

9 corn and 5.5 steak

9*20+5.5*40 =400

Why an increase in both

corn and steak?

0

1

2

3

4

5

6

7

8

9

10

11

0 5 10 15 20 25

Dozen Ears of Corn

Po

un

ds

of

Ste

ak

~

New x-intercept

= 100 / 20 = 5

New y-intercept = 100 / 40 = 2.5

New consumer equilibrium

2 corn and 1.5 steak

2*20+1.5*40 = 100

Why a decrease in both

corn and steak?

Income Halves

22

Income Expansion Path

0

1

2

3

4

5

6

7

8

9

10

11

0 5 10 15 20 25

Dozen Ears of Corn

Po

un

ds

of

Ste

ak

~

• Indicates the response of the rational consumer

to changes in income alone, prices of steak and

corn being held fixed.

• Arrow indicates increase utility!

• Positive slope – both goods normal goods

• Negative slope – one good is an inferior good

What type of goods

are steak and corn?

0

50

100

150

200

250

300

350

400

450

0 1 2 3 4 5 6

Pounds of Steak

Inc

om

e

Engel Curve

Steaks – normal or inferior good? Income and Steaks

Quantity Income

5.5 400

2.5 200

1.5 100

http://ingrimayne.com/econ/elasticity/engel_curve.htm

What about corn?

Engel Curve

Quantity

Inco

me

Normal Good Inferior Good

Quantity

Inco

me

23

Engel Curve

What type of good is this?

Quantity

Inco

me

Summary - Know Summary - Know

• Know Key terms / questions

• What is utility?

• What are indifference curves?

– Direction of preferences

– MRS

– MU

• Know how to graph / interpret a budget

constraint

– Changing prices

– Changing income

Summary - Know

• Consumer equilibrium for an individual for a given price and budget

• Individual consumer’s demand schedule

• Market demand curve

• Price and income expansion paths

• Engel curves

• Change in demand vs. change in quantity demanded

• Consumer surplus