AAEC 2305Fundamentals of Ag Economics

Chapters 3 and 4—Part 1

Economics of Demand

Objectives

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

that can be purchased– About “Utility” & how the principal of

indifference allows us to analyze decisions– How a demand curve is determined by an

individual ‘s budget & indifference (tastes and preferences)

Objectives (Cont.)

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

– The determinants of demand elasticity

Introduction• In this section we will examine the

economic concepts of consumption & demand.

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

(budget)– The scarce goods available in the

marketplace & their prices– The individual’s taste & preferences

(indifference)

Law of Demand

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

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

quantity demanded of that product increases.– The question of how much will be the subject

of analysis later on.

Consumption & Utility

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

characteristics or qualities that make a product desirable, utility may be objective or subjective.• T/F, it is unlikely that two individuals would obtain

the same level of utility (satisfaction) from the same amount of a product.

Consumption & Utility

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

Marginal Utility

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

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

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

Law of Diminishing Marginal Utility

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

ExampleConsumption Total Utility(doughnuts)

0 01 242 423 524 565 566 557 45

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 Constraint

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

to use for consumption–Our budget constrains or limits how

much we can buy

Budget Constraint

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

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

Budget Line

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

TB = (Pg1 * G1) + (Pg2 * G2)

Example Assume TB = 30, Pg1 = 1, & Pg2 = 2

30150

30912

30618

30324

30030

Total Expenditure

G2G1

Budget Line

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

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

and vice versa.

Budget Line

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

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

Effects of Budget Changes

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

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

• Ex. of a budget increase

Effects of a Price change

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

• Ex. of price change

Indifference Curves

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

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

Indifference Curves

G1 G2(Tacos) (Sandwiches)

25 519 614 810 117 155 20

• Each combination of goods provides the same level of utility.

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

Indifference Curves

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

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

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

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

Indifference Curves

• As we move along the IC the utility level remains the same but quantities of goods consumed change as one good replaces (or substitutes) for the other.

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

substitute for another in the consumption process

Marginal Rate of Substitution

• MRS is the slope of the indifference curve.• Marginal Rate of Substitution of G2 for G1

(MRSG2G1) = G1 / G2 = replaced / added

• MRSG2G1 = G1 / G2 = MUG2 / MUG1

Marginal Rate of Substitution

157

205

-0.40

-0.75

1110

-1.33

814

-2.50

619

-6

525

MRSG2G1G2G1

Possible MRS Relationships

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

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

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

Consumer Choice Problem

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

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

the most utility per dollar spent.

Utility Maximization Decision

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

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

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

Utility Maximization Decision

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

• MRSG2G1 = IPR • G1 / G2 = PG2 / PG1

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

Utility Maximization Decision

205

-210-2-0.405-2

157

-28-3-0.754-3

1110

-26-4-1.333-4

814

-24-5-2.502-5

619

-22-6-6.001-6

525

IPRG2*PG2G1*PG1MRSG1G2G2G1G2G1

Utility Maximization Decision

• Recall –• MRSG2G1 = G1 / G2 = MUG2 / MUG1

• We can specify (MRSG2G1 = IPR) as:

MUG2 / MUG1 = PG2 / PG1

MUG2 / PG2 = MUG1 / PG1

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

Impact of Changes in Product Prices• IF PG2 increases-

– G2 becomes relatively more expensive than G1

– The slope of the budget line increases and the budget line rotates inward

– The consumer can no longer afford to remain on original indifference curve and must reduce consumption

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

Impact of Changes in Product Prices• IF PG2 decreases-

– G2 becomes cheaper relative to G1– The slope of the budget line decreases and

the budget line rotates outward– The consumer can afford to move to a higher

indifference curve and can increase consumption

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

Deriving a Demand Curve

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

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

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

Demand Curve

• The demand curve slopes downward and to the right.

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

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

Market Demand

• To get market demand, we aggregate individual demand curves by horizontal summation

• Market Demand—a schedule showing the amount of goods consumers are willing and able for a series of prices during a given period in the market

Demand “Shifters”

• On a demand graph, the axes are price and quantity– Any change in price or quantity is a movement

along the curve (or “change in quantity demanded”)

• But remember that this curve is ceteris paribus, or all other things equal– Any change in any other variable related to

demand shifts the demand curve in or out or changes the slope (or, “change in demand”)

Demand “Shifters”

• Population– The more buyers, ceteris paribus, the greater

demand (remember that we are horizontally summing individuals)

• Income– Per capita or other income measures give an

indication of individual budget constraints• Normal good—when income increases, demand

increases• Inferior good—when income increases, demand

decreases

Demand “Shifters”

• Tastes and Preferences (the shape of indifference curves)– Age, environment, and other geographic and

cultural factors can change tastes– New information about health or other factors– Advertising and changes in fashion– Technological change

Demand “Shifters”

• Price of related goods– Substitutes—increase in the price of the substitute leads

to an outward shift of own good (think steak and chicken)– Complements—increase in the price of the complement

leads to an inward shift of own good (think strawberries and shortcake)

• Expectations– Changes in expectations about futures prices, income,

product availability can affect demand as well• Little home purchasing going on despite low mortgage rates

Elasticity of Demand (ED)

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

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

Elasticity of Demand (ED)

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

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

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

Own-Price Elasticity of Demand

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

• ED = % QD / % P <or>

• ED = ((Q2-Q1)/(Q2+Q1)) / ((P2-P1)/(P2+P1))

Classifications of Own-Price Elasticity of Demand

• Classifications:– Inelastic demand ( |E| < 1 ): a change in price

brings about a relatively smaller change in quantity.

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

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

Cross Price Elasticity of Demand• EDAB

= ((Q2A – Q1A) / (Q2A + Q1A)) / ((P2B –

P1B) / (P2B + P1B)) • Shows the percentage change in the

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

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

Classification of Cross-price elasticity of

Demand• Substitutes in consumption (EDAB > 0): implies

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

• Complements in consumption (EDAB < 0): implies

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

• Independent in consumption (EDAB = 0): implies

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

Income Elasticity of Demand (EDI

)• Since a demand curve represents the

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

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

Income Elasticity of Demand (EDI

)• The direction of the shift depends on if the

good is a normal or inferior good. – Normal good (aka as superior good)– demand

increase with income (& vice versa)– Inferior good – demand decreases with

increases in income (& vice versa)

Income Elasticity of Demand (EDI

)

• EDI = % QD / % I <or>

• EDI = ((Q2-Q1)/(Q2+Q1)) / ((I2-I1)/(I2+I1)

• If EDI > 0, then the good is considered a

normal good.

• If EDI < 0, then the good is considered an

inferior good.

Engel’s Law

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