Principles of Economics Class 2 Demand and consumer behavior

Utility Utility (u or TU)is a pleasure that consumer gains when he consumes goods and services. Marginal utility MU is an increase in utility when quantity of consumed products increases by one unit. Law of diminishing MU states that MU becomes diminishes when the amount of consumed goods increases. Observation of marginal values was started in 1870’s bz Jevons, Menger and Walras.

Total utility and marginal utility

Indifference curves map Indifference curve is a curve that connects all the baskets (combinations) of goods that give the same value of pleasure to a consumer. Its slope is Marginal rate of substitution MRS which tells what is the amount of good Y a consumer is willing to give up in order to get additional unit of X staying on the same level of utility.

u2u2 qyqy 0 qxqx u3u3 u4u4 u1u1 Δ q x = 1 Δ q y = MRS xy Indifference curves map

Budget Consumer can buy only those combinations of goods that satisfy the following rule: (where p = price and q = quantity) The slope of a budget line equal to ratio of prices The area below and on the budget line is affordable with the income I.

qyqy 0 qxqx

Consumer equilibrium The equilibrium is obtained when budget line is tangent to indifference curve. In that case there is no other consumer basket on the budget line that can yield higher utility.

u2u2 qyqy 0 qxqx u3u3 u1u1 Affordable area

Changes in the equilibrium qyqy 0 u1u1 qxqx u2u2 Price of X falls Price-consumption curve qyqy 0 u1u1 qxqx u2u2 Income increases Income-consumption curve

Income and substitution effect INCOME EFFECT is the change in the consumer’s equilibrium due to a change in the purchasing power. SUBSTITUTION EFFECT is the change in the consumer’s equilibrium due to a change in relative prices while retaining the same utilitz level.

u2u2 qyqy 0 qxqx u1u1 Substitution effect Income effect

qyqy 0 u1u1 qxqx qxqx Deduction of an individual demand u2u2 pxpx 0 d The smaller the price of X, the greater its demanded quantity Px falls

Deduction of the market demand dMdM p 0 q Market demand is a horizontal summation of individual demands (competitive good)

Causes of demand shifts d p 0 q Price of complement rises, Price of substitute falls Income falls (normal good), Income rises (inferior good) Good becomes less useful or more substitutable Price of complement falls, Price of substitute rises Income rises (normal good), Income falls (inferior good) Good becomes more useful or less substitutable

d p 0 q s E Consumer’s surplus Producer’s surplus Consumer surplus is the difference between the price consumer pays and the price he was willing to pay. Producer surplus is the difference between the price the seller charges and the price at which he was willing to sell. Consumer’s and producer’s surplus

Exercise 1 Consumer buys 3 goods, A, B and C. The pleasure of consumption of these goods increases as THE consumer increases the quantity: Q = A B C A)Calculate marginal utilities for each good B)If the consumer has 52$ and prices of goods A, B and C are 1$, 2$ and 4$ respectively find the optimal consumption basket when consumer spends the entire income. C)What if income falls down to 36$? D)Draw TU and MU for good B

Exercise 2 1)Let a consumer have the income of 150$ which can be spent on shirts and pullovers. Price of a shirt is 5$ and price of a pullover is 24$. He spends the entire income. a)When consumers maximizes his utility? MU x /P x =MU y /P y

3 combinations=> 1) 3(s) and 4(P) -> 3*5$ + 4*25$ = 115$ 2) 5(s) and 5(P) -> 5*5$ + 5*25$ = 150$ 3) 7(s) and 6(P) -> 7*5$ + 6*25$ = 185$ Consumer maximizes his utilitz when he buys 5 shirts and 5 pullovers Total utility (TU) =TU(p)+TU(s)= = 1750

b)Pri kojoj kombinaciji košulja i pulovera potrošač maksimizira svoju korisnost ako se dohodak smanji na 115$ i kolika je ukupna korisnost? Potrošač max. svoju korisnost pri kombinaciji od 4 pulovera i 3 košulja! Ukupna korisnost(TU) =TU(p)+TU(k)= = 1465

c)Is it possible to acquire the same level of utility if price of shirt 10$ and price of pullover 50$ having the income of 280$? TU =1750 for A) 5 pullovers and 5 shirts (5*10$+5*50$) = 300$ B) 7 pullovers and 0 shirts (7*50$+0*10$) = 350$ It is no longer possible to maintain the previous level of utilitz with the given prices and income. Note: by how much changed prices and the income? It can give you an immediate answer to c)!

Exercise 3 James is ready to pay 10 kn for the first bottle of coke, for the second 8 kn, 3 rd 6 kn and 4 th 4kn. Find his consumer surplus if the current price of a bottle of coke is 4 kn. TABLICA CS = = 12! b)If the price went up to 6 kn what is the amount of consumer’s surplus? = 6 !

Exercise 4 Demand and supply equations are qd = 10 – 2p and qs = 0.5p. Find CS, PS and the equilibrium price and quantity. 10 – 2p = 0.5p => p*= 4, q*= 2. CS = (5 – 4)*2/2 = 1 PS = (4 – 0)*2/2 = 4 TS = 5