AGEC/FNR 406 LECTURE 4

Collecting fragments of coal in a rail yard in China

Theory of Consumer Demand

Lecture Goals:

1. Briefly review of demand theory

2. Discuss features of demand curves.

3. Identify importance of these concepts for environmental and resource economics.

Utility

Because resources provide utility, individuals want them.

Utility = “value” (not necessarily in $ terms)

Four basic laws of demand

1. Consumers prefer more to less

2. Value rises at a decreasing rate

3. Consumers aim to balance consumption

4. Consumers face budget constraints

Example: utility from coal

0 1 2 3 4 5 6 7

Units of coal

utility

Utility is increasing at a decreasing rate

60

50

40

30

20

10

0

Indifference curve: two forms of recreation

Beach trips

Ski tripsAt all points along the indifference curve, an individual is “indifferent” about receiving the corresponding bundles of goods.

Indifference curve: two forms of recreation

Beach trips

Ski trips

Individuals substitute

Indifference curve: two forms of recreation

Beach trips

Ski trips

Utility is increasing“more is better”

Utility MaximizationTwo part process

Part 1

Beach trips

Ski trips

Budget Constraint:

At all points along the budget constraint, an individual’s incomeis completely exhausted.

Income PSKI

Income PBEACH

0 0

•

•

Utility MaximizationTwo part process

Part 2

Beach trips

Ski trips

Income PSKI

Income PBEACH

0 0

•

•

Tangency:

Tangency of budget constraint with the indifference curve identifies the point of optimal consumption for the individual. This corresponds to a single point (price-quantity combination) on the demand curve.

•# skitrips

# beach trips

Points to ponder: 1

The fact that utility is increasing at a decreasing rate means that the first few units of an environmental improvement will have a larger impact on individuals (and society) than subsequent improvements.

Examples: clean water, clean air, nationalparks, reductions in pesticide

residue or pesticide exposure.

Points to ponder: 2

The mixture of environmental quality and consumer goods that we observe is the result of a lot of individual decisions about what tradeoffs are acceptable.

Points to ponder: 3

Consumers prefer more to less, but have finite resources and are forced to make tradeoffs.

This pattern is also repeated at the level of society.

Points to ponder: 4

The budget constraint depends onboth income and prices.

When prices change, this will cause a shift in patterns of consumption due to “income” and “substitution” effects.

Points to ponder: 5

Higher incomes mean we can enjoy more environmental improvements, if we choose to.

Poor individuals and poor countries are generally more sensitive to the tradeoffs that environmental improvements require.