Chapter Five The Demand Curve and the Behavior of Consumers

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 2 The Demand Curve and the Behavior of Consumers Need to determine exactly what determines the slope and position of the demand curve Also need to examine the behavior of consumers to see how well a market economy actually works

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 3 Figure 5.1: A Typical Demand Curve

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 4 Utility and Consumer Preferences Utility is a numerical indicator of a person’s preference for some goods compared to others. If activity A is preferred to activity B, then the utility from A is greater than the utility from B. Be careful not to confuse utility with “usefulness”. Utility describes enjoyment rather than tangible benefit. Example: TV watching vs. Studying

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 5 Figure 5.2: Example of Utility from Grapes and Bananas

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 6 A Consumer’s Utility Depends on the Consumption of Goods Looking at the table, note that a consumer gets more utility from 2 pounds of grapes and 1 pound of bananas (20) than from 1 pound of grapes and 1 pound of bananas (16). The addition of 1 pound of grapes increases utility by 4, which is called marginal utility. Marginal utility is the increase in utility from consuming an additional unit of a good.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 7 Utility Indicates Preference We can rank utilities since it is a numerical value. However, in some cases there are ties. We say the consumer is indifferent as to the two situations. Of all possible combinations, the one with the highest (maximum) utility is the one that is preferred to all the others. Consumers maximize utility by making decisions that lead to the most preferred outcome from the viewpoint of the consumer.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 8 Utility Indicates Preference It doesn’t matter what units are used to measure utility. Important to note: Can NOT compare one person’s utility to another’s. Can only compare one person’s utility for a particular good with the consumer’s utility for another good.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved5 - 9 Budget Constraint and Utility Maximization Budget Constraint: Income limitation on a person’s expenditure on goods and services –Depends on price of goods and services –In general, a higher price for a good reduces consumption opportunities for the individual

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.3: The Budget Constraint ($8) and Expenditure at Two Different Prices

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Maximizing Utility Subject to the Budget Constraint Utility Maximization: The assumption that people try to achieve the highest level of utility given their budget constraint Changes when price changes (shifts ALONG the demand curve)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.4: Maximizing Utility Subject to the Budget Constraint at Two Different Prices

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Change in Income (Shift in the demand curve) When an individual’s income is reduced, they aren’t able to buy as many goods. When income decreases, the ENTIRE demand curve shifts left. When income increases, the ENTIRE demand curve shifts right. Income Effect: The amount by which the quantity demanded falls because of the decline in real income from a price increase

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.5: Income Effect – New Budget Constraint of $6

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Substitution Effect Substitution Effect: The amount by which quantity demanded falls when the price rises, exclusive of the income effect. –In English: If the cost of grapes goes up but other goods do not, grapes are RELATIVELY more expensive. People will switch their purchases to things other than grapes.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Income and Substitution Effects Quantity of GrapesQuantity of BananasType of Effect Original Quantity Demanded ($8 Budget Constraint and $1 per pound) 44 Budget Constraint becomes $6 33Income Effect Price of Grapes Doubled (Budget Constraint is $8) 24Substitution Effect

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Measuring Willingness to Pay and Marginal Benefits Marginal Benefit: The increase in the benefit from, or the willingness to pay for, one more unit of a good. Diminishing Marginal Benefits: Marginal benefit decreases as quantity increases Quantity Willingness to pay for x Marginal Benefit 00.00_____

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.6: Derivation of the Individual Demand Curve (Using Table 5.1 on p. 114): Consumers only buy when PRICE = MARGINAL BENEFIT

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.7: A Smooth Individual Demand Curve (Connecting the dots derived from marginal benefit)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.8: Derivation of the Market Demand Curve (Sum of Individual Market Demand Curves)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Consumer Surplus Consumer Surplus: The difference between what a person is willing to pay for an additional unit of a good and the market price of the good. It is the area below the market demand curve and above the market price.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.9: Consumer Surplus for an Individual

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5.10: Consumer Surplus for the Market

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.1: Budget Line for a Consumer

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.2: Effect of a Change in Income on the Budget Line

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.3: Effect of a Higher Price of X on the Budget Line

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.4: An Indifference Curve for a Consumer

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.5: Higher and Lower Indifference Curves

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.6: The Best Choice for the Consumer

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.7: An Increase in the Price of X

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.7: An Increase in the Price of X (cont’d)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.8: A Decrease in Income

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 5A.9: Illustration of Income Effect and Substitution Effect of a Price Change