Demand and the

Consumer

Marginal Utility Theory

• Utility and consumer satisfaction

• Total and marginal utility– diminishing marginal utility

• The optimum level of consumption– consumer surplus

• marginal consumer surplus

• total consumer surplus

• consumer surplus and the marginal utility curve

40

50

60

70

80

90

100

110

120

0 250 500 750 1000

MU

, P (

penc

e p

er li

tre)

Q (litres per annum)

Tina’s marginal utility from petrol

ConsumerConsumersurplussurplus

40

50

60

70

80

90

100

110

120

0 250 500 750 1000

a

b

c

MU

, P (

penc

e p

er li

tre)

MU

Q (litres per annum)

Tina’s marginal utility from petrol

Marginal Utility Theory

• Utility and consumer satisfaction

• Total and marginal utility– diminishing marginal utility

• The optimum level of consumption– consumer surplus

• marginal consumer surplus

• total consumer surplus

• consumer surplus and the marginal utility curve

– rational consumer behaviour

Marginal Utility Theory

• Utility and consumer satisfaction

• Total and marginal utility– diminishing marginal utility

• The optimum level of consumption– consumer surplus

• marginal consumer surplus

• total consumer surplus

• consumer surplus and the marginal utility curve

– rational consumer behaviour• maximising consumer surplus: P = MU

MU

P1

Q1O

MU, P

Q

Consumer surplus

Totalconsumer

expenditureMU

P1

Q1O

MU, P

Q

Consumer surplus

Totalconsumer

expenditureMU

Total consumer surplus

P1

Q1

MU, P

QO

Consumer surplus

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

MU = D

MU, P

QO Q1

P1

aConsumption at Q1

where P1 = MU

Deriving an individual person’s demand curve

Q2O

P1

Q1

a

P2

b

Consumption at Q2

where P2 = MU

MU, P

Q

MU = D

Deriving an individual person’s demand curve

P2

Q2O

P1

Q3Q1

a

P3

c

Consumption at Q3

where P3 = MU

b

MU, P

Q

MU = D

Deriving an individual person’s demand curve

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

• the shape of the demand curve

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

• the shape of the demand curve

• shifts in the demand curve

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

• the shape of the demand curve

• shifts in the demand curve

• Limitations of the one-commodity version

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

• the shape of the demand curve

• shifts in the demand curve

• Limitations of the one-commodity version

– marginal utility affected by consumption of other goods

Marginal Utility Theory

• Marginal utility and the demand curve

– an individual’s demand curve

– the market demand curve

• the shape of the demand curve

• shifts in the demand curve

• Limitations of the one-commodity version

– marginal utility affected by consumption of other goods

– marginal utility of money not constant

Risk, Uncertainty and Insurance

• Demand under conditions of risk and uncertainty– the problem of imperfect information

• Attitudes towards risk and uncertainty– defining risk and uncertainty

– types of odds

– risk attitudes• risk neutral

• risk loving

• risk averse

• Diminishing marginal utility of income and attitudes towards risk taking

– most people are risk averse

– diminishing marginal utility of incomes

Risk, Uncertainty and Insurance

TU

5000 10 000 15 0000

U1a

Income (£)

To

tal u

tility

Total utility of income

TU

5000 10 000 15 0000

U2

U1a

b

Income (£)

To

tal u

tility

Total utility of income

TU

5000 10 000 15 0000

U3

U2

U1a

b

c

Income (£)

To

tal u

tility

Total utility of income

TU

5000 10 000 15 0000 8000

U3

U2

U1

U4

a

b

c

Income (£)

To

tal u

tility

d

Total utility of income

• Insurance: a way of removing risks

– how insurers spread risks

• the law of large numbers

• importance of the independence of risks

– problems for insurers

• adverse selection

• moral hazard

Risk, Uncertainty and Insurance

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

f3

s3

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

h1

t1

f1

s1O

The characteristics of two brands of breakfast cereal

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

– changes in a product's characteristics

f3

s3

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

h1

t1

f1

s1O

The characteristics of two brands of breakfast cereal

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

– changes in a product's characteristics

• The budget constraint

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

– changes in a product's characteristics

• The budget constraint– affects how much of each characteristic

can be purchased

f3

s3

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

h1

t1

f1

s1O

The characteristics of two brands of breakfast cereal

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

– changes in a product's characteristics

• The budget constraint– affects how much of each characteristic

can be purchased• effects of a change in the budget

f2

s2

f3

s3

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

h2

h1

t1

f1

s1O

The characteristics of two brands of breakfast cereal

The Characteristics Approach

• Consumer choice between products– importance of products' characteristics

• Identifying & plotting characteristics– plotting a product's mix of

characteristics

– changes in a product's characteristics

• The budget constraint– affects how much of each characteristic

can be purchased• effects of a change in the budget

• effects of change in a product's price

f2

s2

f3

s3

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

h2

h1

t1

f1

s1O

The characteristics of two brands of breakfast cereal

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased

f2

s2

Assume a given budget and that thisis the maximum amount of Healthbran

that can be afforded for this budget(assuming no Tastyflakes are purchased)

f1

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

a

b

s1O

f3

s3

The efficiency frontier

Alternatively, for the same budget, assume that this amount of

Tastyflakes could be purchased(assuming no Healthbran is purchased)

c The efficiency frontier

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

O

Oatybix

Sweetreats

a

b

c

d

The efficiency frontier: four brands

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

fall

sall

fh

ft

sh st

Qu

ant

ity o

f fib

re

Healthbran

Tastyflakes

Quantity of sugar

a

b

O

c

d

e

Consuming a mixture of two products

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption– indifference curves

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption– indifference curves

• plotting indifference curves

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Quantity of characteristic B

Choosing between brands

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption– indifference curves

• plotting indifference curves

• the shape of the curves

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Quantity of characteristic B

Choosing between brands

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption– indifference curves

• plotting indifference curves

• the shape of the curves

– the optimum consumption point

The Characteristics Approach

• The efficiency frontier– shows the different combinations of

characteristics that can be purchased• interpreting a point on the frontier

– cases of shifts in the frontier

• The optimum level of consumption– indifference curves

• plotting indifference curves

• the shape of the curves

– the optimum consumption point• the tangency point

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Brand 1Brand 2

Brand 3

Quantities of any one ofthree brands that can bepurchased for a given

budget at current prices.Brand 2 is chosen

Quantity of characteristic B

a

b

c

Choosing between brands

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Brand 1

Brand 2

Quantity of characteristic B

e

a

d

c

b

Choosing a mixture of brands

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Brand 1Brand 2

Brand 3

Quantity of characteristic B

a

b

c

d

Choosing between brands

Fall in priceof brand 1.

Brand 1 is now chosen

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Brand 1

Brand 2

Quantity of characteristic B

e

a

d

c

b

Choosing a mixture of brands

Rise in income

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

– changes in a product's characteristics

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

– changes in a product's characteristics• change in slope of product's ray

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

– changes in a product's characteristics• change in slope of product's ray• movement along new ray

I2

Brand 1 (after)

I1

Qu

ant

ity o

f cha

ract

eris

tic A

Brand 1 (before)

Brand 2

Quantity of characteristic B

a

b

c

A change in the characteristics of Brand 1

Brand 2is chosen

Characteristicsof Brand 1 change

Brand 1 isnow chosen

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

– changes in a product's characteristics• change in slope of product's ray• movement along new ray

– changes in tastes

The Characteristics Approach

• Response to various changes– changes in a product's price

• movement along the product's ray• relationship to cross-price elasticity of

demand

– changes in income• parallel movement of efficiency frontier

– changes in a product's characteristics• change in slope of product's ray• movement along new ray

– changes in tastes• shift in indifference curves

The Characteristics Approach

• Usefulness of characteristics approach– helps understand the nature of

consumer choice

– helps firms in understanding the effects of making changes

• to consumer perceptions– through changing product specifications

– by promoting various characteristics through advertising

• repositioning its product

Qu

ant

ity o

f cha

ract

eris

tic A

I1I2I3I4

I5

Brand 1

Brand 2

Brand 3

a

Quantity of characteristic B

b

c

d

Options open to the firm producing Brand 1

e

Effect oflowering prices,or advertising

The Characteristics Approach

• Usefulness of characteristics approach– helps understand the nature of

consumer choice

– helps firms in understanding the effects of making changes

• to consumer perceptions– through changing product specifications

– by promoting various characteristics through advertising

• repositioning its product

• launching a new brand

The Characteristics Approach

• Limitations of characteristics approach– problem in measuring characteristics

– most products have many characteristics

• only two characteristics can be plotted

– problem in identifying indifference curves

• hard for one individual

• more difficult for whole markets– but can divide markets into segments

– consumer tastes change