AAEC 2305AAEC 2305Fundamentals of Ag Fundamentals of Ag

EconomicsEconomics

Chapter 2Chapter 2

Economics of DemandEconomics of Demand

ObjectivesObjectives

To gain an understanding:To gain an understanding:• About the Law of DemandAbout the Law of Demand• How an individual’s budget limits the How an individual’s budget limits the

goods that can be purchasedgoods that can be purchased• About “Utility” & how an indifference About “Utility” & how an indifference

curve is derivedcurve is derived• How a demand curve is determined by How a demand curve is determined by

an individual ‘s budget & taste & an individual ‘s budget & taste & preferencespreferences

Objectives (Cont.)Objectives (Cont.)

• The basic concepts of elasticity of The basic concepts of elasticity of demand, cross-price elasticity, and demand, cross-price elasticity, and income elasticityincome elasticity

• The determinants of demand The determinants of demand elasticityelasticity

IntroductionIntroduction

In this chapter we will examine the In this chapter we will examine the economic concepts of consumption & economic concepts of consumption & demand.demand.

Factors affecting the consumption Factors affecting the consumption decision:decision:• How much money an individual has to How much money an individual has to

spend (budget)spend (budget)• The scarce goods available in the The scarce goods available in the

marketplace & their pricesmarketplace & their prices• The individual’s taste & preferencesThe individual’s taste & preferences

Law of DemandLaw of Demand

The law of demand states that, ceteris The law of demand states that, ceteris paribus, the quantity of a product paribus, the quantity of a product demanded will vary inversely to the demanded will vary inversely to the price of that product.price of that product.• As the price of a commodity increases, the As the price of a commodity increases, the

quantity demanded of that product quantity demanded of that product decreases.decreases.

• As the price of a commodity decreases, the As the price of a commodity decreases, the quantity demanded of that product quantity demanded of that product increases.increases.

Consumption & UtilityConsumption & Utility

Utility – the satisfaction derived from Utility – the satisfaction derived from consuming a product, good, or serviceconsuming a product, good, or service• Since utility is derived from the inherent Since utility is derived from the inherent

characteristics or qualities that make a characteristics or qualities that make a product desirable, utility may be objective product desirable, utility may be objective or subjective.or subjective.

• T/F, it is unlikely that two individuals T/F, it is unlikely that two individuals would obtain the same level of utility would obtain the same level of utility (satisfaction) from the same amount of a (satisfaction) from the same amount of a product.product.

Consumption & UtilityConsumption & Utility

Util - a hypothetical numerical Util - a hypothetical numerical measurement of utility (used to measurement of utility (used to represent the satisfaction derived represent the satisfaction derived from consuming products)from consuming products)

Marginal UtilityMarginal Utility

Marginal Utility (MU) – addition to Marginal Utility (MU) – addition to total utility (TU) provided by the total utility (TU) provided by the last unit of the good consumedlast unit of the good consumed• MU = Δ TU / Δ ConsumptionMU = Δ TU / Δ Consumption

MU is the utility provided by the MU is the utility provided by the last unit of the good consumedlast unit of the good consumed

MU is central to understanding MU is central to understanding consumption decisions & the law of consumption decisions & the law of demand.demand.

Law of Diminishing Marginal Law of Diminishing Marginal UtilityUtility

Law of Diminishing Marginal Utility Law of Diminishing Marginal Utility - as additional units of a good are - as additional units of a good are consumed a point is always consumed a point is always reached where the utility derived reached where the utility derived from each additional unit declines.from each additional unit declines.

ExampleExample

Consumption Total Utility(doughnuts)

0 01 242 423 524 565 566 557 45

Example (Cont.)Example (Cont.)

Consumption Total Utility Marginal (doughnuts) Utility

0 0> 24

1 24> 18

2 42> 10

3 52> 4

4 56> 0

5 56> -1

6 55> -10

7 45

Budget ConstraintBudget Constraint

Budget – amount of money (from Budget – amount of money (from salary, loans, dividends, etc.) salary, loans, dividends, etc.) available for purchases in a given available for purchases in a given time period.time period.• We all have a limited amount of We all have a limited amount of

money to use for consumptionmoney to use for consumption• Our budget constrains or limits Our budget constrains or limits

how much we can buyhow much we can buy

Budget ConstraintBudget Constraint

Budget Constraint – price & Budget Constraint – price & availability of goods in the market, availability of goods in the market, along with the size of the budget, along with the size of the budget, place a constraint on consumption.place a constraint on consumption.

Budget and budget constraint are Budget and budget constraint are represented by the budget line.represented by the budget line.

Budget LineBudget Line

Budget Line – a line indicating all Budget Line – a line indicating all combinations of two goods that combinations of two goods that can be purchased using all of the can be purchased using all of the consumer’s budget.consumer’s budget.

TB = (PTB = (Pg1g1 * G * G11) + (P) + (Pg2g2 * G * G22))

ExampleExample Assume TB = 30, PAssume TB = 30, Pg1g1 = 1, & P = 1, & Pg2 g2 = 2= 2

3030151500

3030991212

3030661818

3030332424

3030003030

Total ExpenditureTotal ExpenditureG2G2G1G1

Budget LineBudget Line

Every combination of goods along Every combination of goods along the budget line can be purchased the budget line can be purchased for the same total expenditure.for the same total expenditure.

The distance from the origin is an The distance from the origin is an indication of the size of a the indication of the size of a the budget.budget.• The closer to the origin, the lower the The closer to the origin, the lower the

budget and vice versa.budget and vice versa.

Budget LineBudget Line

Only purchases on the budget line Only purchases on the budget line use all of the consumer’s budget.use all of the consumer’s budget.

The utility maximizing combination The utility maximizing combination - where consumption is optimum - - where consumption is optimum - lies somewhere on the budget lies somewhere on the budget constraint.constraint.

Effects of Budget ChangesEffects of Budget Changes

A budget increase will result in a A budget increase will result in a parallel shift of the budget line to parallel shift of the budget line to the rightthe right

Conversely, a budget decrease will Conversely, a budget decrease will result in a parallel shift of the result in a parallel shift of the budget line to the left.budget line to the left.

Ex. of a budget increaseEx. of a budget increase

Effects of a Price changeEffects of a Price change

If the price of one good If the price of one good changes, slope of budget changes, slope of budget line changesline changes

Ex. of price changeEx. of price change

Indifference CurvesIndifference Curves

Indifference Curve (IC) - a line Indifference Curve (IC) - a line showing all combinations of two showing all combinations of two goods (products) that provide the goods (products) that provide the same level of utilitysame level of utility

T/F, each combination of products T/F, each combination of products along the IC provides the same level along the IC provides the same level of utilityof utility• i.e., the consumer is indifferent between i.e., the consumer is indifferent between

themthem

Indifference CurvesIndifference Curves Each combination of goods Each combination of goods

provides the same level of provides the same level of utility.utility.

The downward slope of the IC The downward slope of the IC indicates that if the consumer indicates that if the consumer gives up one good, the gives up one good, the resulting loss in utility must resulting loss in utility must be compensated for by be compensated for by consuming additional units of consuming additional units of the other commodity for the other commodity for utility to remain constant.utility to remain constant.

G1 G2(Tacos) (Sandwiches)25 519 614 810 117 155 20

Indifference CurvesIndifference Curves

Since each IC represents a unique level of Since each IC represents a unique level of utility, an IC exists for each level of utility utility, an IC exists for each level of utility a consumer is capable of experiencing. a consumer is capable of experiencing.

T/F, the distance from the origin indicates T/F, the distance from the origin indicates the level of utilitythe level of utility

T/F, each IC represents a unique utility T/F, each IC represents a unique utility level - - Hence, IC can never intersectlevel - - Hence, IC can never intersect

Additionally, the whole set of IC is called Additionally, the whole set of IC is called an indifference map.an indifference map.

Indifference CurvesIndifference Curves As we move along the IC the utility level As we move along the IC the utility level

remains the same but quantities of goods remains the same but quantities of goods consumed change as one good replaces (or consumed change as one good replaces (or substitutes) for the other.substitutes) for the other.

Marginal rate of substitution (MRS) - rate Marginal rate of substitution (MRS) - rate one good must or can decreased as one good must or can decreased as consumption of the other good increasesconsumption of the other good increases• i.e., rate at which one good can physically i.e., rate at which one good can physically

substitute for another in the consumption substitute for another in the consumption processprocess

Marginal Rate of Marginal Rate of SubstitutionSubstitution

MRS is the slope of the indifference MRS is the slope of the indifference curve.curve.

Marginal Rate of Substitution of G2 Marginal Rate of Substitution of G2 for G1 (MRSfor G1 (MRSG2G1G2G1) = ) = G1 / G1 / G2 = G2 = replaced / replaced / addedadded

MRSMRSG2G1G2G1 = = G1 / G1 / G2 = MUG2 = MUG2G2 / MU / MUG1G1

Marginal Rate of Marginal Rate of SubstitutionSubstitution

151577

202055

-0.40-0.40

-0.75-0.75

11111010

-1.33-1.33

881414

-2.50-2.50

661919

-6-6

552525

MRSMRSG2G1G2G1GG22GG11

Possible MRS Possible MRS RelationshipsRelationships

Imperfect Substitutes – diminishing Imperfect Substitutes – diminishing MRS; one good can be exchanged for MRS; one good can be exchanged for another, but at a decreasing rate.another, but at a decreasing rate.

Perfect (Constant) Substitutes – Perfect (Constant) Substitutes – constant MRS; one unit of a good can constant MRS; one unit of a good can be exchanged for another on a be exchanged for another on a constant basis.constant basis.

Perfect Complements – Fixed Perfect Complements – Fixed Proportions; goods must be consumed Proportions; goods must be consumed in a fixed ratioin a fixed ratio

Consumer Choice ProblemConsumer Choice Problem

The basic problem a consumer faces is The basic problem a consumer faces is how to allocate the budget among how to allocate the budget among various goods to maximize utility various goods to maximize utility (satisfaction).(satisfaction).

A rational consumer maximizes utility by A rational consumer maximizes utility by consuming as many goods as desired, consuming as many goods as desired, within the limits imposed by the budget.within the limits imposed by the budget.• i.e. - the consumer buys goods that provide i.e. - the consumer buys goods that provide

the most utility per dollar spent.the most utility per dollar spent.

Utility Maximization Utility Maximization DecisionDecision

Obj. of the consumer is to find the combination Obj. of the consumer is to find the combination of goods that provides the maximum amount of goods that provides the maximum amount of utility for his/her given budget (income).of utility for his/her given budget (income).

T/F, the consumer wants to reach the highest T/F, the consumer wants to reach the highest possible level of utility, given their budget possible level of utility, given their budget constraint.constraint.

I.e., consumer wants to find tangency between I.e., consumer wants to find tangency between the highest possible indifference curve (utility) the highest possible indifference curve (utility) and the budget line (budget constraint).and the budget line (budget constraint).

Utility Maximization Utility Maximization DecisionDecision

Tangency occurs where slope of the Tangency occurs where slope of the indifference curve equals the slope of indifference curve equals the slope of the budget line.the budget line.

MRSMRSG2G1G2G1 = IPR = IPR G1 / G1 / G2 = PG2 = PG2G2 / P / PG1G1

Can be viewed as:Can be viewed as:((G1 * PG1 * PG1G1) = () = (G2 * PG2 * PG2G2))““Budget Savings” = “Budget Budget Savings” = “Budget

Expenditures”Expenditures”

Utility Maximization Utility Maximization DecisionDecision

202055

-2-21010-2-2-0.40-0.4055-2-2

151577

-2-288-3-3-0.75-0.7544-3-3

11111010

-2-266-4-4-1.33-1.3333-4-4

881414

-2-244-5-5-2.50-2.5022-5-5

661919

-2-222-6-6-6.00-6.0011-6-6

552525

IPRIPRG2*PG2*PG2G2G1*PG1*PG1G1MRSMRSG1G2G1G2G2G2G1G1G2G2G1G1

Utility Maximization Utility Maximization DecisionDecision

Recall –Recall – MRSMRSG2G1G2G1 = = G1 / G1 / G2 = MUG2 = MUG2G2 / MU / MUG1G1

We can specify (MRSWe can specify (MRSG2G1G2G1 = IPR) as: = IPR) as:

MUMUG2G2 / MU / MUG1G1 = P = PG2G2 / P / PG1G1

MUMUG2G2 / P / PG2G2 = MU = MUG1G1 / P / PG1G1

* Utility max occurs where MU per dollar * Utility max occurs where MU per dollar spent is equal for the two goods.spent is equal for the two goods.

Impact of Changes in Product Impact of Changes in Product PricesPrices

IF PIF PG2G2 increases- increases-• G2 becomes relatively more expensive G2 becomes relatively more expensive

than G1than G1• The slope of the budget line increases The slope of the budget line increases

and the budget line rotates inwardand the budget line rotates inward• The consumer can no longer afford to The consumer can no longer afford to

remain on original indifference curve remain on original indifference curve and must reduce consumption and must reduce consumption

• T/F, the consumer will consume less of T/F, the consumer will consume less of G2 and more of G1.G2 and more of G1.

Impact of Changes in Product Impact of Changes in Product PricesPrices

IF PIF PG2G2 decreases- decreases-• G2 becomes cheaper relative to G1G2 becomes cheaper relative to G1• The slope of the budget line decreases The slope of the budget line decreases

and the budget line rotates outwardand the budget line rotates outward• The consumer can afford to move to a The consumer can afford to move to a

higher indifference curve and can higher indifference curve and can increase consumptionincrease consumption

• T/F, the consumer will consume more T/F, the consumer will consume more of G2 and less of G1.of G2 and less of G1.

Deriving a Demand CurveDeriving a Demand Curve

Demand Schedule – information on price and Demand Schedule – information on price and quantity (consumption) combinations that give quantity (consumption) combinations that give the consumer maximum utility, ceteris paribus.the consumer maximum utility, ceteris paribus.

Demand Curve – a line connecting all Demand Curve – a line connecting all combinations of price and quantities consumed combinations of price and quantities consumed • Each point on a demand curve gives the price Each point on a demand curve gives the price

and quantity combination of a good that a and quantity combination of a good that a consumer will buy, given his or her budget consumer will buy, given his or her budget constraint and the prices of other goods.constraint and the prices of other goods.

Demand CurveDemand Curve

The demand curve slopes downward The demand curve slopes downward and to the right.and to the right.

Each point on the demand curve Each point on the demand curve gives a quantity of the good that a gives a quantity of the good that a consumer will buy to maximize utility.consumer will buy to maximize utility.

Refer to class example on how to Refer to class example on how to derive a demand curve.derive a demand curve.

Elasticity of Demand (EElasticity of Demand (EDD))

Elasticity of demand is defined as the Elasticity of demand is defined as the percentage change in the quantity percentage change in the quantity demanded relative to a percentage demanded relative to a percentage change in the price as we move from change in the price as we move from one point to another on a demand one point to another on a demand curve.curve.

Elasticity of demand represents Elasticity of demand represents movement along the demand curve and movement along the demand curve and thus elasticity is also a measure of the thus elasticity is also a measure of the degree of slope of the demand curve.degree of slope of the demand curve.

Elasticity of Demand (EElasticity of Demand (EDD))

Mgrs. & Economists are interested in two Mgrs. & Economists are interested in two types of demand elasticity measures:types of demand elasticity measures:• Own-price elasticity: measures the Own-price elasticity: measures the

responsiveness of the quantity demanded of responsiveness of the quantity demanded of a good to changes in the price of that good.a good to changes in the price of that good.

• Cross-price elasticity: measures the Cross-price elasticity: measures the responsiveness of the quantity demanded of responsiveness of the quantity demanded of a good to changes in the price of a related a good to changes in the price of a related good.good.

Own-Price Elasticity of Own-Price Elasticity of DemandDemand

The own-price elasticity of demand The own-price elasticity of demand is calculated as follows:is calculated as follows:

EEDD = % = % Q QD D / % / % P P <or><or>

EEDD = ((Q = ((Q22-Q-Q11)/(Q)/(Q22+Q+Q11)) / )) / ((P((P22-P-P11)/(P)/(P22+P+P11))))

Classifications of Own-Classifications of Own-Price Elasticity of DemandPrice Elasticity of Demand

Classifications:Classifications:• Inelastic demand ( |E| < 1 ): a Inelastic demand ( |E| < 1 ): a

change in price brings about a change in price brings about a relatively smaller change in quantity.relatively smaller change in quantity.

• Unitary elastic demand ( |E| = 1 ): a Unitary elastic demand ( |E| = 1 ): a change in price brings about an change in price brings about an equivalent change in quantity.equivalent change in quantity.

• Elastic demand ( |E| > 1 ): a change Elastic demand ( |E| > 1 ): a change in price brings about a relatively in price brings about a relatively larger change in quantity.larger change in quantity.

Cross Price Elasticity of Cross Price Elasticity of DemandDemand

EEDDABAB = ((Q = ((Q2A2A – Q – Q1A1A) / (Q) / (Q2A2A + Q + Q1A1A)) / ((P)) / ((P2B2B

– P– P1B1B) / (P) / (P2B2B + P + P1B1B)) )) Shows the percentage change in the Shows the percentage change in the

quantity demanded of good A in quantity demanded of good A in response to a change in the price of response to a change in the price of good B.good B.

Read as the cross-price elasticity of Read as the cross-price elasticity of demand for commodity A with demand for commodity A with respect to commodity B.respect to commodity B.

Classification of Classification of Cross-price elasticity of Cross-price elasticity of

DemandDemand

Substitutes in consumption (ESubstitutes in consumption (EDDABAB > 0): implies > 0): implies

that as the price of good B increases, the that as the price of good B increases, the quantity demanded of Good A by the consumer quantity demanded of Good A by the consumer also increases (& vice versa).also increases (& vice versa).

Complements in consumption (EComplements in consumption (EDDABAB < 0): < 0):

implies that as the price of good B decreases, implies that as the price of good B decreases, the quantity demanded of Good A by the the quantity demanded of Good A by the consumer also increases (& vice versa).consumer also increases (& vice versa).

Independent in consumption (EIndependent in consumption (EDDABAB = 0): implies = 0): implies

that the price of good B has no effect on that the price of good B has no effect on quantity demanded of Good A.quantity demanded of Good A.

Income Elasticity of Income Elasticity of Demand (EDemand (EDDII

))

Since a demand curve represents the Since a demand curve represents the amount at each price that consumers amount at each price that consumers are WILLING and ABLE to purchase, the are WILLING and ABLE to purchase, the amount of income available to amount of income available to consumers has a direct effect on their consumers has a direct effect on their effective demand.effective demand.

If consumer’s income increases If consumer’s income increases (decreases), the position of the (decreases), the position of the demand curve will also change (shift).demand curve will also change (shift).

Income Elasticity of Income Elasticity of Demand (EDemand (EDDII

))

The direction of the shift depends The direction of the shift depends on if the good is a normal or inferior on if the good is a normal or inferior good. good. • Normal good (aka as superior good)– Normal good (aka as superior good)–

demand increase with income (& vice demand increase with income (& vice versa)versa)

• Inferior good – demand decreases with Inferior good – demand decreases with increases in income (& vice versa)increases in income (& vice versa)

Income Elasticity of Income Elasticity of Demand (EDemand (EDDII

))

EEDDII = % = % Q QDD / % / % I I <or> <or>

EEDDI I = ((Q= ((Q22-Q-Q11)/(Q)/(Q22+Q+Q11)) / ((I)) / ((I22-I-I11)/(I)/(I22+I+I11))

If EIf EDDII > 0, then the good is considered a > 0, then the good is considered a

normal good.normal good. If EIf EDDII

< 0, then the good is considered < 0, then the good is considered

an inferior good.an inferior good.

Engel’s LawEngel’s Law

The percentage of total income The percentage of total income spent on food generally declines as spent on food generally declines as income increases resulting in an income increases resulting in an income elasticity of demand for income elasticity of demand for the total quantity of food less than the total quantity of food less than one, a relationship known as one, a relationship known as Engel’s Law.Engel’s Law.