Demand Analysis

Some Questions What is behind a consumer’s demand curve? How do consumers choose from among various consumer “goods”? What determines the value of a consumer good?

What is Consumer Theory? Study of how people use their limited means to make purposeful choices. Assumes that consumers understand their choices (possibilities) and the prices (opportunity costs) associated with each choice. Assumes that consumers consider the alternatives and choose the one they like best.

Consumer Theory - Why? Two important reasons: –to understand the foundations of market demand (bake the demand curve from scratch) –to address several interesting consumer theory issues that are best understood using this model rather than the aggregate demand model

Two Components of Consumer Demand Opportunities: –What can the consumer afford? –What are the consumption possibilities? –Summarized by the budget constraint Preferences: –What does the consumer like? –How much does a consumer like a good? –Summarized by the utility function

Utility The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice. In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called “utility”. Consumers, however, cannot have every thing they wish to have. Consumers’ choices are constrained by their incomes. Within the limits of their incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their “utilities.”

Our basic assumptions about a “rational” consumer: Consumers are utility maximizers Consumers prefer more of a good (thing) to less of it. Facing choices X and Y, a consumer would either prefer X to Y or Y to X, or would be indifferent between them. Transitivity: If a consumer prefers X to Y and Y to Z, we conclude he/she prefers X to Z Diminishing marginal utility: As more and more of good is consumed by a consumer, ceteris paribus, beyond a certain point the utility of each additional unit starts to fall.

How to Measure Utility Measuring utility in “utils” (Cardinal): Jack derives 10 utils from having one slice of pizza but only 5 utils from having a burger. In many introductory microeconomics textbooks this approach to measuring utility is still considered effective for teaching purposes. Measuring utility by comparison (Ordinal): Jill prefers a burger to a slice of pizza and a slice of pizza to a hotdog. Often consumers are able to be more precise in expressing their preferences. For example, we could say: Jill is willing to trade a burger for four hotdogs but she will give up only two hotdogs for a slice of pizza. We can infer that to Jill, a burger has twice as much utility as a slice of pizza, and a slice of pizza has twice as much utility as a hotdog.

Utility and Money Because we use money (rather than hotdogs!) in just about all of our trade transactions, we might as well use it as our comparative measure of utility. (Note: This way of measuring utility is not much different from measuring utility in utils) Jill could say: I am willing to pay $4 for a burger, $2 for a slice of pizza and $1 for a hotdog. Note: Even though Jill obviously values a burger more (four times as much) than a hot dog, she may still choose to buy a hotdog, even if she has enough money to buy a burger, or a slice of pizza, for that matter. (We will see why and how shortly.)

Total Utility versus Marginal Utility 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. Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period, ceteris paribus. Total utility = Sum of marginal utilities

The Law of Diminishing Marginal Utility Over a given consumption period, the more of a good a consumer has, or has consumed, the less marginal utility an additional unit contributes to his or her overall satisfaction (total utility). Alternatively, we could say: 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 to fall.

Total and Marginal Utility for Ice Cream

How much ice cream does Jill buy in a month? Some facts of life: Limited income Opportunity cost of making a choice: Buying ice cream leaves Jill less money to buy other things: each dollar spent on ice cream could be spent on hamburger. In fact, consumers compare the (expected) utility derived from one additional dollar spent on one good to the utility derived from one additional dollar spent on another good.

What is a Budget Constraint? A budget constraint shows the consumer’s purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income. The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.

THE BUDGET LINE: What is Attainable Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ Quantity of A Quantity of B

Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ Quantity of A Quantity of B THE BUDGET LINE: What is Attainable

Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ Quantity of A Quantity of B THE BUDGET LINE: What is Attainable

Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ Quantity of A Quantity of B THE BUDGET LINE: What is Attainable

Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ Quantity of A Quantity of B THE BUDGET LINE: What is Attainable

Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ (Attainable) Quantity of A Quantity of B (Unattainable) THE BUDGET LINE: What is Attainable

THE BUDGET LINE: What is Attainable Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ (Attainable) Quantity of A Quantity of B (Unattainable) An Increase in income makes the purchase of more of either or both items possible

THE BUDGET LINE: What is Attainable Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ (Attainable) Quantity of A Quantity of B (Unattainable) Price changes cause a change in the quantity demanded of the items

INDIFFERENCE CURVES What is Preferred Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 j

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 j k INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 j k l INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 j k l m INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 j k l m I INDIFFERENCE CURVES What is Preferred

I2I2 Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 j k l m The slope represents the marginal rate of substi- tution, (MRS) I1I1 INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 I1I1 If the consumer had greater income, more of either or both products could be purchased INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 I1I1 A higher combination of choices will be preferred I2I2 I3I3 I4I4 INDIFFERENCE CURVES What is Preferred

Quantity of A Quantity of B Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 I1I1 I2I2 I3I3 I4I4 A family of all such expressions of indifference can be developed for every level of income An Indifference Map INDIFFERENCE CURVES What is Preferred

EQUILIBRIUM AT TANGENCY I1I1 I2I2 Quantity of A Quantity of B I3I3 I4I4 (Attainable) (Unattainable) Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $ An Indifference Schedule Combi- nation Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8

Quantity of A Quantity of B (Attainable) (Unattainable) Equilibrium occurs when the consumer selects the combination which reaches the highest attainable indifference curve. I1I1 I2I2 I3I3 I4I4 EQUILIBRIUM AT TANGENCY

What happens if the price of B increases to $1.50? Price B Quantity B $1.006 I3I3 The budget line rotates reflecting the reduction in the quantity of B units which is attainable. Quantity of A Quantity of B EQUILIBRIUM AT TANGENCY

What happens if the price of B increases to $1.50 ? Price B Quantity B $ By recording the various quantities demanded at the various prices yields the Demand schedule I2I2 I3I3 The budget line rotates reflecting the reduction in the quantity of B units which is attainable. Quantity of A Quantity of B EQUILIBRIUM AT TANGENCY

What happens if the price of B increases to $1.50 ? Price B Quantity B $ By recording the various quantities demanded at the various prices yields the Demand schedule I2I2 I3I3 The budget line rotates reflecting the reduction in the quantity of B units which is attainable. Quantity of A Quantity of B EQUILIBRIUM AT TANGENCY

What happens if the price of B increases to $1.50 ? Price B Quantity B $ By recording the various quantities demanded at the various prices yields the demand schedule. DERIVING THE DEMAND CURVE Price of B Quantity of B $ DBDB Plotting the Points yields the Demand Curve for Product B