DEMAND & CONSUMER BEHAVIOUR

AIMS & OBJECTIVESAfter studying this lesson, you will be able to understand: Concept of Utility & utility theory Law of diminishing marginal utility & Law of equi-marginal

utility Consumer’s equilibrium Downward slope of demand curve Income effect & substitution effect Market demand curve The paradox of value Consumer Surplus Indifference Curve, budget constraint & consumer’s

equilibrium Price Consumption Curve Income Consumption Curve

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SLOPE OF DEMAND CURVE: EXPLAINED WITH UTILITY ANALYSIS Recall: A demand curve, each point on which shows the

quantity purchased of a good at a given prices, is downward sloping as quantity demanded of a good is inversely related to its price

Now Qs. is: Why does quantity demanded move in the opposite direction to that of price?

Answer to this lies in utility analysis.

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UTILITY ANALYSIS Utility refers to the usefulness of a good Two important concepts of utility are: Total Utility (TU) and

Marginal Utility (MU)• TU – sum total of utility derived from all units of a good

consumed• MU – additional utility derived from each additional unit of a

good consumed. Thus,

• MU = d(TU)/dq = MUn+1 – Mun

• Where ‘q’ denotes units consumed and ‘n’ and ‘(n+1)’ denotes two successive units consumed

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RELATION BETWEEN TU & MU

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MU measures the rate of change in TU. It gives the change in utility with an additional unit of the good consumed

TU rises at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU diminishes, becomes zero and becomes negative thereafter

TU may sometimes rise initially at an increasing rate, then at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU rises at first, then diminishes, then becomes zero and becomes negative thereafter

Quantity of a good consumed

Total Utility

Marginal Utility

1 4 4

2 7 3

3 9 2

4 10 1

5 10 0

6 8 -2

LAW OF DIMINISHING MARGINAL UTILITY Marginal utility usually diminishes throughout or may rise

briefly at first and then diminish throughout. This tendency leads to a very important law – the Law of Diminishing Marginal Utility (LDMU)

The Law states - As a consumer consumes more and more units of a particular good, the Marginal utility derived from each additional unit diminishes

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CONSUMER’S EQUILIBRIUM

Equilibrium for any economic agent refers to a state of balance in terms of his receipts & what he has to forego

For a consumer the balance is ensured when the utility he receives from consumption of a good is equal to what he foregoes by the way of price he pays for the good

SLOPE OF DEMAND CURVE EXPLAINED BY LDMU Let a consumer buying/consuming good X be initially in

equilibrium i.e. MUx = Px i.e. what he is receiving as utility is exactly balanced by what he is foregoing as price. He is making the best use of his resources to reach the maximum satisfaction/value

Now let Px ↓ ⇒ MUx > Px ⇒ equilibrium disturbed. The consumer is now getting more value than he is foregoing. So he would want to get more and increase his consumption ⇒ Qx ↑. As Qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx = Px . The consumer reaches equilibrium once again. In the process Qx ↑. Thus as Px ↓ Qx ↑ which explains the inverse prices quantity relationship for a product.

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LAW OF EQUI-MARGINAL UTILITY (LEMU) In the real world a consumer takes his consumption decision

not with respect to one product but with respect to a number of products he purcahes/consumes. Thus, he does not quite reach his equilibrium when MUx = Px

He reaches his equilibrium when marginal utility of his expenditure in all directions of his purchases are equalized i.e. if he is buying two goods X & Y at prices Px & Py then he is in equilibrium when

MUx/Px = MUy/Py = MUm

where Mum denotes marginal utility from total money he has.

This is referred to as consumers’ equilibrium as per law of equi-marginal utility

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SLOPE OF DEMAND CURVE EXPLAINED BY LEMU Let a consumer buying/consuming two goods X & Y be

initially in equilibrium i.e. MUx/Px = MUy/Py i.e. the marginal utility of expenditure on X is equal to the marginal utility of expenditure on Y. Hence he consumes both and maximizes his utility.

Now let Px ↓ ⇒ MUx/Px > MUy/Py ⇒ equilibrium disturbed. The consumer’s MU of expenditure on X is greater than MU of expenditure on Y and hence he wants buy more of X with his scarce money ⇒ Qx ↑. As Qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx/Px = MUy/Py . The consumer reaches equilibrium once again. In the process Qx ↑. Thus as Px ↓ Qx ↑ which explains the inverse prices quantity relationship for a product

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SLOPE OF A DEMAND CURVE REVISITED The inverse price-quantity relationship and hence the

downward slope of a demand curve may also be explained with the help of the following two concepts:

Income effect Substitution effect

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INCOME EFFECT When the price of a commodity falls less has to be spent on

the purchase of the same quantity of the commodity. This leads to an increase in purchasing power of the money with the buyer. This is referred to an increase in real income of the consumer.

The increase in real income leads to an increase in purchase of the commodity whose price has fallen. This is referred to as income effect of a price change.

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Px ↓ → Real income ↑→ Qx ↑

INCOME EFFECT NEGATIVE OR POSITIVE? Px ↓ → Real income ↑→ Qx ↑ ⇒ income effect is positive ⇒

X is a normal good

Px ↓ → Real income ↑→ Qx ↓ ⇒income effect is negative ⇒ X is an inferior good

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SUBSTITUTION EFFECT When price of a commodity falls, its becomes cheaper

relative to other commodities. This leads to substitution of other commodities( which are now relatively more expensive) by this commodity. Thus the demand for the cheaper good rises. This is called the substitution effect.

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Px ↓→ it is relatively cheaper and hence attractive→ Qx ↑

SUBSTITUTION EFFECT NEGATIVE OR POSITIVE? Substitution effect is always positive.

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INFERIOR GOOD VS GIFFEN GOOD A good with negative income effect is referred to as inferior

good A good whose negative income effect dominates the positive

substitution effect is a Giffen good. Thus, all Giffen goods are inferior goods but all inferior

goods are not Giffen goods

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MARKET DEMAND CURVE The market demand curve is the sum of individual demands

at each price Graphically, a market demand curve is the horizontal

summation of individual demand curves

THE PARADOX OF VALUE Why does water so essential and hence valuable for life

command either a small or no price? While diamond which is only an item of conspicuous consumption command such a high price?

The answer lies in the fact that while diamond is scarce, water is abundant. Besides, as price for water is fixed based on additional units of consumption, the additional units of utility derived from consumption of additional units of water gradually diminishes.

CONSUMER’S SURPLUS This refers to the difference between what a consumer is

willing to pay and what he actually pays

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D

P

Q

A

D’

Consumer surplus

FURTHER BEHIND THE DEMAND CURVE Consumers equilibrium can also be explained using the two

concepts of:• Indifference curve• Budget Line

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INDIFFERENCE CURVES An indifference shows various combinations of two goods

that fetches the same level of utility/satisfaction to the consumer

Basic Characteristics of Indifference Curves Higher indifference curves represent higher levels of

utility Indifference curves do not intersect. Indifference curves slope downward. Indifference curves are concave to origin.

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SLOPE OF AN INDIFFERENCE CURVE & MRSXY Slope of an Indifference Curve = - dY/dX = the Marginal rate

of technical substitution between X & Y (MRSxy) = -MUX/MUY

The Marginal rate of technical substitution between X & Y (MRSxy) represents the rate at which X gets substituted for Y as a consumer moves down an indifference curve

The MRSxy diminishes as one moves down an indifference curve. This is the Law of Diminishing Marginal Rate of substitution. This explains the concave to the origin (or convex from the origin) property of an indifference curve

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BUDGET CONSTRAINTS Budget constraint shows the various combinations of two goods that

a consumer can have for a given money outlay If a consumer is buying only two goods X and Y in quantities x & y

respectively and at prices Px and Py respectively with his entire income M then

M = xPx + yPy

This represents the consumer’s budget constraint or budget line Basic Characteristics of Budget Constraints

Shows affordable combinations of X and Y. Slope of –PX/PY reflects relative prices.

Effect of increase in relative prices Slope of Budget line changes. It shifts outward/inward with one of its

points either on Y axis(when Px changes) or on X axis (when Py changes) remaining fixed

Effects of Changing Income with prices constant Income increase causes parallel outward shift. Income decrease causes parallel inward shift.

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OPTIMAL CONSUMPTION/CONSUMER’S EQUILIBRIUM A consumer does his optimal consumption at the point

where his utility is maximized subject to this budget constraint i.e. he reaches the highest possible indifference curve given the budget constraint

Mathematically, this Utility Maximization happens when the budget line becomes tangent to the highest possible indifference curve for the consumer. At this point slope of budget line becomes equal to slope of indifference curve (IC) i.e.

-PX/PY = - MRSxy = - MUX/MUY. i.e.

MUX/PX = MUY/PY.

Condition for Consumer’s equilibrium. This is same as obtained from Law of equi-marginal utility 26

Each of A, B, C represents consumer’s Equilibrium for different budget constraint faced by the consumer.

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PRICE CONSUMPTION CURVE, INCOME CONSUMPTION CURVE, ENGLE CURVE Price-consumption Curve

Shows how consumption is affected by price changes (movement along demand curve).

Income-consumption Curve Shows how consumption is affected by income changes

(shifts from one demand curve to another). Engle Curves

Plot between income and quantity consumed. Consumption of normal goods rises with income. Consumption of inferior goods falls with income (rare).

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