The Demand Side of the The Demand Side of the Market Market - - PowerPoint PPT Presentation

The Demand Side of the The Demand Side of the Market Market

Econ Dept, UMR Presents

N Utility Theory N Consumer Surplus N Elasticity

Starring Starring

Featuring Featuring

N NThe MU/ P Rule

The MU/ P Rule

N NThe Meaning of Value

The Meaning of Value

N NFour Elasticities:

Four Elasticities:

O OPrice Elasticity of Demand

Price Elasticity of Demand

O OIncome Elasticity

Income Elasticity

O OCross Price Elasticity

Cross Price Elasticity

O OPrice Elasticity of Supply

Price Elasticity of Supply

N NThe Elasticity-TR relationship

The Elasticity-TR relationship

In Three Parts In Three Parts

Consumer Choice Theory Consumer Choice Theory Consumer Surplus Consumer Surplus Elasticity Elasticity

Consumer Choice Theory Consumer Choice Theory Income/ Substitution Effects Income/ Substitution Effects Utility Theory Utility Theory

Part 1

Assumptions underlying the Assumptions underlying the Consumer choice model: Consumer choice model:

N N Consumers buy competitively, that is

Consumers buy competitively, that is they can buy as much as they want at a they can buy as much as they want at a given price given price

N N Consumers have limited money

Consumers have limited money incomes and sufficient information to incomes and sufficient information to make informed choices make informed choices

N N Consumers are rational

Consumers are rational

N N Consumers seek to maximize their total

Consumers seek to maximize their total utility or satisfaction utility or satisfaction

Consumers Have to Choose Consumers Have to Choose What They Want With Their What They Want With Their Limited Incomes Limited Incomes

? ? ? ? ? ?

Hot Links Hot Links

N N USADATA

USADATA

Jump to USADATA and Click on “Free Examples” to see some data on your buying patterns

Review -- the determinants of Review -- the determinants of consumer demand (PINTE): consumer demand (PINTE):

N N P

P: The : The price of the product price of the product, and the , and the prices of substitutes and complements prices of substitutes and complements available to the consumer available to the consumer

N N I

I: The : The income income available to the available to the consumer consumer

N N N

N: The : The number number of consumers

• f consumers

N N T

T: The consumer’s : The consumer’s tastes tastes and and preferences preferences

N N E

E: The consumer’s : The consumer’s expectations expectations about about future income, wealth, and prices future income, wealth, and prices

Basic Demand Theory Basic Demand Theory

N N Law of Demand - The rule that

Law of Demand - The rule that consumers buy more at low prices than consumers buy more at low prices than they do at high prices. they do at high prices.

N N The Law may be argued from an

The Law may be argued from an analysis of: analysis of:

O O The Income/ Substitution Effect

The Income/ Substitution Effect of a Price

• f a Price

Change, or Change, or

O O Utility Theory

Utility Theory - A theory of consumer

• A theory of consumer

behavior in which people buy goods based behavior in which people buy goods based

• n the satisfaction they expect to derive
• n the satisfaction they expect to derive

from those goods. from those goods.

First, We’ll Look at the Income First, We’ll Look at the Income and Substitution Effect of a and Substitution Effect of a Price Change Price Change

N N Price changes affect consumers in two

Price changes affect consumers in two ways: ways:

O O Income effects

Income effects: Consumption changes

: Consumption changes because purchasing power changes. because purchasing power changes.

O O Substitution effects

Substitution effects: Consumption

: Consumption changes because opportunity costs change. changes because opportunity costs change.

Income Effect of a Price Change Income Effect of a Price Change

N N When the price of a product

When the price of a product falls falls, a , a consumer has consumer has more more purchasing power purchasing power with the same amount of income with the same amount of income

N N When the price of a product

When the price of a product rises rises, a , a consumer has consumer has less less purchasing power with purchasing power with the same amount of income the same amount of income

N N More purchasing power will

More purchasing power will increase increase the the demand for demand for normal normal goods and goods and decrease decrease the demand for the demand for inferior inferior goods goods

Normal vs Inferior vs Giffen Normal vs Inferior vs Giffen Goods Goods

N N Normal Goods

Normal Goods - Those that consumers buy

• Those that consumers buy

more of as their real incomes rise and less of more of as their real incomes rise and less of as their real income falls as their real income falls

N N Inferior Goods

Inferior Goods - Those goods consumers buy

• Those goods consumers buy

more of as their income falls and less of as more of as their income falls and less of as their income rises their income rises

N N Giffen Goods

Giffen Goods - Those

• Those inferior

inferior goods with an goods with an income effect that moves in the same income effect that moves in the same direction as price and for which the income direction as price and for which the income effect is larger than the substitution effect effect is larger than the substitution effect.

.

Substitution Effects of a Price Substitution Effects of a Price Change Change

N N When the price of a product

When the price of a product falls falls, that , that product becomes product becomes more more attractive attractive relative to potential substitutes relative to potential substitutes

N N When the price of a product

When the price of a product rises rises, that , that product becomes product becomes less less attractive relative attractive relative to potential substitutes to potential substitutes

N N The substitution effect implies the

The substitution effect implies the demand curve will be downward sloping demand curve will be downward sloping

Income vs. Substitution Effect Income vs. Substitution Effect

N N Income Effect

Income Effect - The change in quantity

• The change in quantity

demanded of a good due to a change in real demanded of a good due to a change in real income caused by a change in the price of a income caused by a change in the price of a good good

N N Substitution Effect

Substitution Effect - The change in the quantity

• The change in the quantity

demanded of a good resulting from a change in demanded of a good resulting from a change in its price relative to the price of other goods its price relative to the price of other goods

N N Usually,

Usually, normally normally,the two effects work ,the two effects work together--increase in Q together--increase in QD

D when P falls and

when P falls and decrease in Q decrease in QD

D when P increases

when P increases

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of a Fall in Price of a Normal

Normal Good

Good

Price Falls Real Income Increases QD Increases

Substitution Effect Income Effect P Q/t D

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of an Fall in Price of an Inferior

Inferior*

* Good

Good

Price Falls Real Income Increases QD Decreases

S u b s t i t u t i

• n

S u b s t i t u t i

• n

E f f e c t

Income Effect

QD Increases

QD Increases

Total Effect =

*Inferior, but not a Giffen

Good

P Q/t D

Income, Substitution Effect of a Income, Substitution Effect of a Fall in Price of a Fall in Price of a Giffen

Giffen Good

Good

Price Falls Real Income Increases QD Decreases

S u b s t i t u t i

• n

S u b s t i t u t i

• n

E f f e c t

Income Effect

QD Increases

QD Decreases

Total Effect =

P Q/t D

N N Both effects work to explain the law of

Both effects work to explain the law of demand demand

N N Only in the case of inferior goods is an

Only in the case of inferior goods is an upward sloping demand possible upward sloping demand possible

N N Even with inferior goods, the substitution

Even with inferior goods, the substitution effect will outweigh the income effect unless effect will outweigh the income effect unless

O O the good is strongly inferior and occupies a large

the good is strongly inferior and occupies a large portion of a person’s budget portion of a person’s budget

O O the market is dominated by persons for whom the

the market is dominated by persons for whom the good is a Giffen good good is a Giffen good

N N Economists are still looking for a Giffen good

Economists are still looking for a Giffen good

Summary: The Law of Demand and the Income - Substitution Effect

Now, lets look at the law of Now, lets look at the law of demand and consumer demand and consumer choice within the context of choice within the context of Utility Theory Utility Theory

N N We need to establish some basic

We need to establish some basic concepts concepts

O O The budget constraint

The budget constraint

O O Total and Marginal Utility

Total and Marginal Utility

O O The common sense of the MU/ P rule

The common sense of the MU/ P rule

Budget Constraint Budget Constraint

N NThe limits imposed on

The limits imposed on consumer choices by income, consumer choices by income, wealth, and product prices wealth, and product prices

Showing the Budget Showing the Budget Constraint Graphically Constraint Graphically

B I = Income per period = $200 I = Income per period = $200 P PX = Price of Good X = $10 = Price of Good X = $10 P PY = Price of Good Y = $5 = Price of Good Y = $5 X/t Y/t 20 40 = I/PY = I/PX Slope = - 40/20 = - (I/P Slope = - 40/20 = - (I/PY)/(I/P )/(I/PX) ) = - P = - PX/P /PY

Showing A Decrease in Income Showing A Decrease in Income

B I = Income per period = $200 I = Income per period = $200 P PX = Price of Good X = $10 = Price of Good X = $10 P PY = Price of Good Y = $5 = Price of Good Y = $5 Slope = - 40/20 = - (I/P Slope = - 40/20 = - (I/PY)/(I/P )/(I/PX) ) = - P = - PX/P /PY 20 40 = I/PY = I/PX X/t Y/t

New Income = $100 New Income = $100

20 10

Parallel shift inward, Parallel shift inward, slope doesn’t change slope doesn’t change

B I = Income per period = $200 I = Income per period = $200 P PX = Price of Good X = $10 = Price of Good X = $10 P PY = Price of Good Y = $5 = Price of Good Y = $5 Slope = - 40/20 = - (I/P Slope = - 40/20 = - (I/PY)/(I/P )/(I/PX) ) = - P = - PX/P /PY 20 40 = I/PY = I/PX X/t Y/t

Both Prices Double Both Prices Double

20 10

Parallel shift inward, slope doesn’t change Parallel shift inward, slope doesn’t change since since relative relative prices didn’t change prices didn’t change

Showing A Change in Prices Showing A Change in Prices

Showing A Change in Showing A Change in A A Price Price

B I = Income per period = $200 I = Income per period = $200 P PX = Price of Good X = $10 = Price of Good X = $10 P PY = Price of Good Y = $5 = Price of Good Y = $5 P PY2

Y2 = New Price of Good Y =

= New Price of Good Y = $10 $10 20 40 = I/PY = I/PX X/t Y/t

Price of Y Double Price of Y Double

20 10

Rotation from the X axis, slope changes since Rotation from the X axis, slope changes since relative relative prices change prices change

Slope = - 20/20 Slope = - 20/20 = -(P = -(PX/P /PY2

Y2)/(I/P

)/(I/PX) = - P ) = - PX/P /PY2

Y2

The basis of choice: Utility The basis of choice: Utility

N N The budget constraint shows

The budget constraint shows us the combinations of two us the combinations of two goods that a consumer goods that a consumer CAN

CAN

buy buy

N N What else do we need to know

What else do we need to know to determine what the to determine what the consumer consumer W ILL

W ILL buy?

buy?

Utility Utility

N N The satisfaction, or reward, a

The satisfaction, or reward, a product yields relative to its product yields relative to its alternatives alternatives

N N Impossible to measure

Impossible to measure

N N Cannot be compared across people

Cannot be compared across people

N N Helps us to better understand

Helps us to better understand consumer choice consumer choice

Some Definitions for Utility Some Definitions for Utility Theory Theory

N N Total utility

Total utility is the total amount of is the total amount of satisfaction obtained from satisfaction obtained from consumption of a good, service, or consumption of a good, service, or activity activity

N N Marginal utility

Marginal utility is the is the additional

additional

satisfaction gained by the satisfaction gained by the consumption or use of consumption or use of one more unit

• ne more unit of
• f

a good, service, or activity a good, service, or activity

N N Util

Util is a unit of satisfaction used to is a unit of satisfaction used to subjectively measure satisfaction subjectively measure satisfaction

Ordinal Measures and Ordinal Measures and Interpersonal Utility Interpersonal Utility Comparisons Comparisons

N N The actual number of utils doesn’t

The actual number of utils doesn’t matter, just the relationship between matter, just the relationship between them. them.

N N For this reason, we can’t compare utils

For this reason, we can’t compare utils between people. We can only compare between people. We can only compare utils between goods, services, or utils between goods, services, or activities for one person. activities for one person.

A Point to Note A Point to Note

N N Utility comes from any activity that

Utility comes from any activity that gives us happiness-viewing a sunset, gives us happiness-viewing a sunset, talking with a person we like, hiking a talking with a person we like, hiking a mountainous trail, or munching a mountainous trail, or munching a candy bar candy bar

N N For convenience, we refer to

For convenience, we refer to “consuming a good” but we mean any “consuming a good” but we mean any activity that we enjoy activity that we enjoy

Total and Marginal Utility Total and Marginal Utility

N N Total Utility

Total Utility (TU) - relates consumption of (TU) - relates consumption of a good to the utility derived from a good to the utility derived from consuming a good consuming a good

N N Marginal Utility

Marginal Utility (MU) - the change in total (MU) - the change in total utility when consumption of a good utility when consumption of a good changes by one unit changes by one unit

O O MU =

MU = ∆

∆TU /

TU / ∆

∆ Q

Q

Law of Diminishing Marginal Law of Diminishing Marginal Utility Utility

N N Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility -

• as more of a good is consumed, the

as more of a good is consumed, the added utility (MU) decreases, ceteris added utility (MU) decreases, ceteris paribus. paribus.

Law of Diminishing Marginal Law of Diminishing Marginal Utility Utility

N N Example

Example

O O If I’m really hungry, I get a lot of

If I’m really hungry, I get a lot of satisfaction from first slice of pizza satisfaction from first slice of pizza

O O As I keep eating pizza, the satisfaction

As I keep eating pizza, the satisfaction from the next slice would be less than that from the next slice would be less than that

• f the first slice
• f the first slice

O O And the MU of the third slice less than that

And the MU of the third slice less than that

• f the second slice
• f the second slice

Notes on the Law of Notes on the Law of Diminishing MU Diminishing MU

N N As with Demand and Supply, Utility is

As with Demand and Supply, Utility is a Flow: A Time Period must be a Flow: A Time Period must be specified specified

N N The Law tells us that the Total Utility

The Law tells us that the Total Utility curve will become “flatter” as curve will become “flatter” as consumption increases consumption increases

O O Slope of the total utility curve is equal to

Slope of the total utility curve is equal to marginal utility marginal utility

Marginal Utility Marginal Utility

MU Q/t MU

Shape of MU Shape of MU

N N Downward sloping

Downward sloping

O O Law of diminishing marginal utility

Law of diminishing marginal utility

N N Always positive

Always positive

N N Rational behavior

Rational behavior

O O Consumer only purchases a good if they

Consumer only purchases a good if they get some positive utility from it. get some positive utility from it.

Total Utility Total Utility

TU Q/t TU ∆ ∆TU TU ∆ ∆Q Q

MU = MU = ˛ ˛TU/ TU/ ˛ ˛Q Q

Region of “too much fun”

Total Utility and Marginal Total Utility and Marginal Utility Utility

TU Q/t At B, MU = 0 ∆ ∆TU TU ∆ ∆Q Q

MU = MU = ˛ ˛TU/ TU/ ˛ ˛Q Q More precisely, MU is More precisely, MU is defined at a point. At defined at a point. At point A, MU = the slope point A, MU = the slope

• f the TU curve
• f the TU curve

A B

Shape of TU Shape of TU

N N Positive slope

Positive slope

O O Consumer only purchases a good if gets

Consumer only purchases a good if gets some positive amount of utility (rational some positive amount of utility (rational behavior) behavior)

N N Slope gets flatter as Q increases

Slope gets flatter as Q increases

O O Law of diminishing marginal utility

Law of diminishing marginal utility

Consumer Equilibrium Consumer Equilibrium

N N Now that we understand the concepts

Now that we understand the concepts

• f utility theory - we will use them to
• f utility theory - we will use them to

explain how consumers make decisions explain how consumers make decisions about what to buy about what to buy

Consumer Equilibrium Consumer Equilibrium

N N How well we like something is

How well we like something is encompassed in the concepts of total encompassed in the concepts of total utility and marginal utility and marginal

N N But I can’t afford to think about what I

But I can’t afford to think about what I like the most, I have to think about what I like the most, I have to think about what I have to give up as well have to give up as well

N N So if I want to maximize my utility, I

So if I want to maximize my utility, I don’t just pick the thing that gives me the don’t just pick the thing that gives me the most pleasure. I have to weigh the price most pleasure. I have to weigh the price

• f the good in my decision as well
• f the good in my decision as well

Allocating Income to Allocating Income to Maximize Utility Maximize Utility

How can we use the information

How can we use the information

• n the budget set and utility
• n the budget set and utility

theory theory to determine the utility

to determine the utility maximizing bundle of goods and maximizing bundle of goods and services services?

?

Utility-Maximizing Rule Utility-Maximizing Rule

N N A utility maximizing consumer allocates his

A utility maximizing consumer allocates his

• r her expenditures such that the marginal
• r her expenditures such that the marginal

utility per dollar spent on each activity is utility per dollar spent on each activity is equal for all activities equal for all activities.

.

O OMU

MUx

x/ P

/ Px

x = MU

= MUAOG

AOG/ P

/ PAOG

AOG

N N For activities not undertaken, or goods not

For activities not undertaken, or goods not bought, the MU/P ratio is less than the ratio bought, the MU/P ratio is less than the ratio for those activities undertaken. for those activities undertaken.

N N This rule is a necessary condition derived

This rule is a necessary condition derived from applying calculus to maximization from applying calculus to maximization

• problems. It also follows from common sense
• problems. It also follows from common sense

as we will see. as we will see.

Consider Fran. She is trying to determine the Consider Fran. She is trying to determine the utility maximizing combination of trips to a utility maximizing combination of trips to a blues club and to a coffee house to take per blues club and to a coffee house to take per week. week. Club Total Marginal CHouse Total Marginal Club Total Marginal CHouse Total Marginal Trips Utility Utility Trips Utility Utility Trips Utility Utility Trips Utility Utility

1 12 12 1 1 12 12 1 20 20 20 20 2 22 10 2 2 22 10 2 36 16 36 16 3 31 9 3 3 31 9 3 50 14 50 14 4 39 8 4 4 39 8 4 62 12 62 12 5 45 6 5 72 10 5 45 6 5 72 10 6 49 4 6 80 8 6 49 4 6 80 8

If club trips cost $3.00 and trips to the coffee house cost $6.00, what will she buy with a $24 budget?

Club Marginal MU/P CHouse Marginal MU/P Trips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

First let’s look at Fran’s First let’s look at Fran’s Weekly Budget Constraint Weekly Budget Constraint

Blues Trips Coffee House Trips 8 4

She may select any combination within the triangle formed by the origin and the budget line, B

B Note: The negative of the slope of the budget constraint is the ratio of relative prices

The Common Sense of Maximizing The Common Sense of Maximizing Utility Utility

Blues Trips Coffee House Trips 8 4 B Club Marginal MU/P CHouse Marginal MU/P

Trips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

4 2

6 1

(6, 1) is on the budget line, but MU/P are not equal MU/P = 1.3 for the blues < 3.7 for the coffee You get more for your $ at the coffee house

Now Apply the MU/ P Rule Now Apply the MU/ P Rule

Blues Trips Coffee House Trips 8 4 B Club Marginal MU/P CHouse Marginal MU/P

Trips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

4 2

Club Marginal MU/P CHouse Marginal

MU/P Trips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

Utility Maximization Requires Utility Maximization Requires Equal MU/ P Ratios and Being on Equal MU/ P Ratios and Being on the Budget Line the Budget Line

Blues Trips Coffee House Trips 8 B 4 2 4 MU/P =, but (6,6) is outside budget

Something To Think About Something To Think About

N N To make life simpler, we

To make life simpler, we compartmentalize problems such as compartmentalize problems such as consumer choice consumer choice

N N Fran has allocated so much of her budget

Fran has allocated so much of her budget to having fun, to clothing, etc. $24 in this to having fun, to clothing, etc. $24 in this example example

N N We are looking at her choice problem

We are looking at her choice problem within the compartment of within the compartment of entertainment-hearing the blues, and entertainment-hearing the blues, and enjoying people/ conversation at the enjoying people/ conversation at the coffee house coffee house

Something Else to Think Something Else to Think About About

N N Visits to the Blues Club and the Coffee

Visits to the Blues Club and the Coffee House has well defined costs-- House has well defined costs-- estimated by a “Price” estimated by a “Price”

N N Often we want things not available for a

Often we want things not available for a $ price $ price

N N When this is the case, we estimate the

When this is the case, we estimate the “cost” subjectively “cost” subjectively

N N Economists estimate these cost

Economists estimate these cost

• bjectively through statistical methods
• bjectively through statistical methods

More Common Sense of the More Common Sense of the MU/ P Rule MU/ P Rule

N N If MU/ P for X = 10 and MU/ P for Y = 5,

If MU/ P for X = 10 and MU/ P for Y = 5, you are getting more pleasure per dollar you are getting more pleasure per dollar buying X buying X

N N As you reallocate spending from Y to X

As you reallocate spending from Y to X (moving on your budget constrain), the (moving on your budget constrain), the MU MUX

X falls and the MU

falls and the MUY

Y increases. This

• increases. This

follows from the law of diminishing MU follows from the law of diminishing MU

N N You continue to reallocate until the ratios

You continue to reallocate until the ratios are equal are equal

The Law of Demand and the The Law of Demand and the MU/ P Rule MU/ P Rule

N N The rational for equating MU/ P ratios to

The rational for equating MU/ P ratios to maximize utility implies the law of maximize utility implies the law of demand demand

N N MU

MUX

X/ P

/ PX

X = MU

= MUY

Y/ P

/ PY

Y now suppose P

now suppose PX

X

falls falls

N N MU

MUX

X/ P

/ PX

X > MU

> MUY

Y/ P

/ PY

Y and you will buy

and you will buy more X more X

N N So the Law of Demand is valid if the

So the Law of Demand is valid if the Law of Diminishing MU is valid Law of Diminishing MU is valid

N N Can you think of

Can you think of any

any exceptions?

exceptions?

We need to wrestle with one We need to wrestle with one more concept to discover the more concept to discover the meaning of Value meaning of Value Consumer Surplus Consumer Surplus

go on to Part 2 go on to Part 2

The End The End

Part 1