7/31/2019 Consumer Demand Theory (1)
1/58
Consumer Demand Theory
7/31/2019 Consumer Demand Theory (1)
2/58
3 Basic Assumptions
Each consumer has complete information on
all matters pertaining to consumer decisions
The consumer knows the range of goods available
in the market and the capacity of the good to
satisfy human wants
The exact price of each good is known.
The consumer knows his income during theplanning period
7/31/2019 Consumer Demand Theory (1)
3/58
3 Basic Assumptions
Given the 3 assumptions, each consumer tries
to maximize utility/satisfaction/happiness
given a limited income.
Utility the satisfaction a consumer derives
from whatever good/service he/she
consumes. This is the basis of choice.
7/31/2019 Consumer Demand Theory (1)
4/58
Two Approaches
Marginal Utility Approach
Indifference Curve Approach
7/31/2019 Consumer Demand Theory (1)
5/58
Marginal Utility Approach
Assumption: Utility is measurable andquantifiable
Util a measure of pleasure or satisfaction
Total Utility (TU) Total utility is the total utilitya consumer derives from the consumption ofall of the units of a good or a combination of
goods over a given consumption period,ceteris paribus.
Total utility = Sum of marginal utilities
7/31/2019 Consumer Demand Theory (1)
6/58
Marginal Utility Approach
Marginal utility is the utility a consumer
derives from the last unit of a consumer good
she or he consumes (during a given
consumption period), ceteris paribus.
- the slope of total utility curve
Q
TUMU
7/31/2019 Consumer Demand Theory (1)
7/58
Hall & Leiberman; Economics:Principles And Applications,
2004
7
Total Utility and Marginal Utility
No of cones Total utility Marginal Utility
0 0 utils
1 30 utils 30 utils
2 50 utils 20 utils
3 60 utils 10 utils
4 65 utils 5 utils
5 68 utils 3 utils
6 69 utils 1 utils
7/31/2019 Consumer Demand Theory (1)
8/58
Hall & Leiberman; Economics:Principles And Applications,
2004
8
Total And Marginal Utility
Total Utility
Marginal Utility
Utils 302010
Ice Cream Cones per Week1 2 3 4 5 6
Utils
605040
70
30
2010
Ice Cream Cones per Week1 2 3 4 5 6
1. The change in total utilityfromone more ice cream cone . . .
2. is called the marginalutility
of an additional cone.
3. Marginal utility falls
as more cones areconsumed.
7/31/2019 Consumer Demand Theory (1)
9/58
Total and Marginal Utility for Ice Cream
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 38 160 0
9 155 -5
10 145 -10
145
7/31/2019 Consumer Demand Theory (1)
10/58
Total Utility
0
50
100
150
200
1 2 3 4 5 6 7 8 9 10 11
($) MU
-20
-10
0
10
20
30
40
50
1 2 3 4 5 6 7 8 9 1 11
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 205 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145
7/31/2019 Consumer Demand Theory (1)
11/58
Total Utility and Marginal Utility
Saturation point a point where increase in
consumption of unit of a good, total utility did
not increase.
In the schedule it is between 7 and 8
7/31/2019 Consumer Demand Theory (1)
12/58
The Law of Diminishing Marginal Utility
Over a given consumption period, as more and more of
a good is consumed by a consumer, beyond a certain
point, the marginal utility of additional units begins tofall.
7/31/2019 Consumer Demand Theory (1)
13/58
CONSUMER SURPLUS
= the gap between the total utility of a good and itstotal market value
The surplus arises because we receive more
than we pay for, it is rooted in the law ofdiminishing marginal utility
we pay for each unit what the last unit is worthbut by the law of diminishing marginal utility the
earlier units are worth more to us than the lastthus, we enjoy a surplus of utility on each ofthese earlier units
7/31/2019 Consumer Demand Theory (1)
14/58
Consumer Surplus
The difference between what a consumer is
willing to pay for an addition unit of a good
and the market price that he/she actually pays
is referred to as consumer surplus.
The area between the demand curve and the
price (line) measures the total consumer
surplus.
7/31/2019 Consumer Demand Theory (1)
15/58
Consumer Surplus
Price
D
Qx
0
P
7/31/2019 Consumer Demand Theory (1)
16/58
Diamond/Water Paradox
The things with the greatest value use
frequently have little or no value in exchange,
and
The things with the greatest value in exchange
frequently have little or no value in use.
7/31/2019 Consumer Demand Theory (1)
17/58
Diamond/Water Paradox
Why is water which is essential to life so cheap
while diamonds which are not essential to life
so expensive?
Water has a great use value but low exchange
value because supply is abundant.
Even at a price of zero we do not consume an
infinite amount of water. We consume up to
the point where MU drops to zero.
7/31/2019 Consumer Demand Theory (1)
18/58
Diamond/Water Paradox
Diamond low use value but high exchange
value.
low supply MU tends to be very high
willing to pay a high price
Price of the good is determined by the MU of
the last unit of a good not by the TU.
7/31/2019 Consumer Demand Theory (1)
19/58
Indifference Curve Analysis
1881 Francis Y. Edgeworth, British
Economist, introduced the IC technique
1906 IC technique was adopted by an Italian
Economist, Vilfredo Pareto
1930s 2 British Economists: John R. Hicks
and Roy George Douglas Allen popularized the
IC technique
7/31/2019 Consumer Demand Theory (1)
20/58
Assumptions on the nature of
consumer preferences
Preferences are complete.
The consumer is able to set up a preference
ranking of the combinations available.
X > Y X is preferred over Y
Y>X Y is preferred over X
X Y indifferent between X and Y
7/31/2019 Consumer Demand Theory (1)
21/58
Assumptions on the nature of
consumer preferences
Preferences are transitive.
The consumer makes choices that are consistent
with each other.
A > B, B>C therefore, A>C
More is better.
The consumer prefers more of any goods or
services to less of it because more goods orservices give her a higher level of satisfaction
7/31/2019 Consumer Demand Theory (1)
22/58
THE THEORY OF CONSUMERCHOICE
22
Preferences: What the Consumer Wants
Quantity
of Fish
Quantity
of Mangos
Indifference curve:
shows consumptionbundles that give the
consumer the same
level of satisfaction
A consumption bundle is aparticular combination of the
goods, e.g., 40 fish & 300
mangos.
A, B, and all other bundleson I1 makes a person
equally happy the person
is indifferentbetween them.
I1
Indifference curve
B
A
7/31/2019 Consumer Demand Theory (1)
23/58
THE THEORY OF CONSUMERCHOICE
23
Four Properties of Indifference Curves
Quantity
of Fish
Quantity
of Mangos
If the quantity offish is reduced,
the quantity of
mangos must be
increased to keep theperson equally happy.
A
Indifference curve
I1
1. Indifference curvesare downward-
sloping.
B
7/31/2019 Consumer Demand Theory (1)
24/58
THE THEORY OF CONSUMERCHOICE
24
Four Properties of Indifference Curves
Quantity
of Fish
Quantity
of Mangos
He prefers every bundleon I2 (like C)
to every bundle on I1
(like A).
Indifference curves
I1
I2
I0
D
2. Higher indifferencecurves are preferred
to lower ones.
He prefers every bundleon I1 (like A)
to every bundle on I0
(like D).
C
A
7/31/2019 Consumer Demand Theory (1)
25/58
THE THEORY OF CONSUMERCHOICE
25
Four Properties of Indifference Curves
Quantity
of Fish
Quantity
of Mangos
If it did, it violates the
transitivity assumption.
A B both are onI1A C - both are on I4
Therefore, B C not true
because C > A
Indifference curves
I1
3. Indifference curvescannot cross.
B
C
I4
A
7/31/2019 Consumer Demand Theory (1)
26/58
THE THEORY OF CONSUMERCHOICE
26
Four Properties of Indifference Curves
Quantity
of Fish
Quantity
of Mangos
He is willing to give up
more mangos for a fish ifhe has few fish (A) than
if he has many (B).
4. Indifference curvesare bowed inward.
I1
1
1
6
2
A
B
7/31/2019 Consumer Demand Theory (1)
27/58
THE THEORY OF CONSUMERCHOICE
27
The Marginal Rate of Substitution
Quantity
of Fish
Quantity
of Mangos
MRS is the amount of
mangos he would
substitute for another
fish. I1
1
1
6
2
A
B
Marginal rate of
substitution (MRS):
the rate at which a consumer
is willing to trade one good for
another.
MRS = is the
negative of theslope of
indifference curve
MRS =
MRS =
MRS falls as you move down
along an indifference curve.
7/31/2019 Consumer Demand Theory (1)
28/58
THE THEORY OF CONSUMERCHOICE
28
One Extreme Case: Perfect SubstitutesPerfect substitutes: two goods with straight-
line indifference curves,constant MRS
Example: nickels & dimes
Consumer is always willing to tradetwo nickels for one dime.
7/31/2019 Consumer Demand Theory (1)
29/58
THE THEORY OF CONSUMERCHOICE
29
Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curvesExample: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
7/31/2019 Consumer Demand Theory (1)
30/58
Less Extreme Cases:
Close Substitutes and Close Complements
Quantity
of Coke
Quantity
of Pepsi
Indifference
curves for close
substitutes are
not very bowed
Quantity
of hot dogs
Quantity
of hot dog
buns
Indifference
curves for
close
complements
are very bowed
7/31/2019 Consumer Demand Theory (1)
31/58
THE THEORY OF CONSUMERCHOICE
31
The Budget Constraint:
What the Consumer Can Afford
Example:Hurley divides his income between two goods:
fish and mangos.
Budget constraint: the limit on the consumption
bundles that a consumer can afford
Shift in the budget constraint:
1. change in income
2. change in the price/s of the goods
7/31/2019 Consumer Demand Theory (1)
32/58
Hurleys income: $1200Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can he
buy?
D. Plot each of the bundles from parts AC on a
graph that measures fish on the horizontal axis and
mangos on the vertical, connect the dots.
A C T I V E L E A R N I N G 1
Budget Constraint
32
7/31/2019 Consumer Demand Theory (1)
33/58
A. $1200/$4
= 300fish
B. $1200/$1= 1200
mangos
C. 100fish cost
$400,$800 left
buys 800
mangos
A C T I V E L E A R N I N G 1
Answers
Quantity
of Fish
Quantity of
Mangos
A
B
C
D. Hurleys budget
constraint shows thebundles he can
afford.
7/31/2019 Consumer Demand Theory (1)
34/58
THE THEORY OF CONSUMERCHOICE
34
The Slope of the Budget Constraint
Quantity
of Fish
Quantity of
Mangos
D
From C to D,
rise =
200 mangos
run =
+50 fishSlope = 4
Hurley must
give up
4 mangos
to get one fish.
C
7/31/2019 Consumer Demand Theory (1)
35/58
THE THEORY OF CONSUMERCHOICE
35
The Slope of the Budget Constraint
The slope of the budget constraint equals
the rate at which Hurley
can trade mangos for fish
the opportunity cost of fish in terms of mangos
the relative price of fish:$
$
price of fish 44 mangos per fish
price of mangos 1
7/31/2019 Consumer Demand Theory (1)
36/58
Show what happens to Hurleys budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango
A C T I V E L E A R N I N G 2
Budget constraint, continued.
36
7/31/2019 Consumer Demand Theory (1)
37/58
Now,Hurley
can buy
$800/$4
= 200 fishor
$800/$1
= 800 mangos
or any
combination in
between.
A C T I V E L E A R N I N G 2
Answers, part A
Quantity
of Fish
Quantity of
Mangos
A fall in income
shifts the budgetconstraint down.
7/31/2019 Consumer Demand Theory (1)
38/58
Hurley
can still buy
300 fish.
But now he
can only buy$1200/$2 =
600 mangos.
Notice:
slope is smaller,relative price of
fish is now only 2
mangos.
A C T I V E L E A R N I N G 2
Answers, part B
Quantity
of Fish
Quantity of
Mangos
An increase in the
price of one goodpivots the budget
constraint inward.
7/31/2019 Consumer Demand Theory (1)
39/58
THE THEORY OF CONSUMERCHOICE
39
Optimization: What the Consumer Chooses
Quantity
of Fish
Quantity
of Mangos
1200
600
300150
A is the optimum:
the point on thebudget constraint
that touches the
highest possible
indifference curve.
Hurley prefers B to A,
but he cannot afford B. A
C
D
Hurley can afford C
and D,
but A is on a higher
indifference curve.
B
The optimum
is the bundleHurley most
prefers out of all
the bundles he
can afford.
7/31/2019 Consumer Demand Theory (1)
40/58
THE THEORY OF CONSUMERCHOICE
40
Optimization: What the Consumer Chooses
Quantity
of Fish
Quantity
of Mangos
1200
600
300150
At the optimum,
slope of the
indifference curve
equals
slope of the budget
constraint:
MRS = PF/PM A
marginalvalue of fish
(in terms of
mangos)
price of fish
(in terms of
mangos)
7/31/2019 Consumer Demand Theory (1)
41/58
THE THEORY OF CONSUMERCHOICE 41
The Effects of an Increase in Income
Quantity
of Fish
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
If both goods are
normal, Hurley
buys more of each.
A
B
7/31/2019 Consumer Demand Theory (1)
42/58
An increase in income increases the quantitydemanded ofnormal goods and reduces the
quantity demanded ofinferior goods.
Suppose fish is a normal goodbut mangos are an inferior good.
Use a diagram to show the effects of
an increase in income on Hurleys optimalbundle of fish and mangos.
A C T I V E L E A R N I N G 3
Inferior vs. normal goods
42
7/31/2019 Consumer Demand Theory (1)
43/58
A C T I V E L E A R N I N G 3
Answers
43
Quantity
of Fish
Quantity
of Mangos
If mangos are
inferior, the new
optimum will contain
fewer mangos.
AB
7/31/2019 Consumer Demand Theory (1)
44/58
THE THEORY OF CONSUMERCHOICE 44
500
350
The Effects of a Price Change
Quantity
of Fish
Quantity
of Mangos
1200
600
300150 600
initial
optimum
newoptimum
Initially,
PF = $4
PM = $1
PF falls to $2budget constraint
rotates outward,
Hurley buys
more fish andfewer mangos.
7/31/2019 Consumer Demand Theory (1)
45/58
THE THEORY OF CONSUMERCHOICE 45
A fall in the price of fish has two effects on
Hurleys optimal consumption of both goods. Income effect
A fall in PFboosts the purchasing power of Hurleys
income, allows him to buy more mangos and more fish.
Substitution effect
A fall in PF makes mangos more expensive relative to fish,
causes Hurley to buy fewer mangos & more fish.
Notice: The net effect on mangos is ambiguous.
The Income and Substitution Effects
7/31/2019 Consumer Demand Theory (1)
46/58
THE THEORY OF CONSUMERCHOICE 46
The Income and Substitution Effects
Initial
optimum at A.
PF falls.
Substitution effect:
from A to B,buy more fish and
fewer mangos.
Income effect:
from B to C,buy more of both
goods. Quantityof Fish
Quantity
of Mangos
A
B
C
In this example,
the net effect on
mangos is
negative.
7/31/2019 Consumer Demand Theory (1)
47/58
Do you think the substitution effect would bebigger for substitutes or complements?
Draw an indifference curve for Coke and Pepsi, and,
on a separate graph, one for hot dogs and hot dogbuns.
On each graph, show the effects of a relative price
change (keeping the consumer on the initialindifference curve).
A C T I V E L E A R N I N G 4
The substitution effect in two cases
47
7/31/2019 Consumer Demand Theory (1)
48/58
But the substitution effect is bigger for substitutesthan complements.
A C T I V E L E A R N I N G 4
Answers
Quantity
of Coke
Quantity
of Pepsi
In both graphs, the relative price changes bythe same amount.
Quantity
of hot dogs
Quantity of
hot dog buns
A
B
A B
Deriving Hurleys Demand Curve for Fish
7/31/2019 Consumer Demand Theory (1)
49/58
$2 DFish
Deriving Hurley s Demand Curve for Fish
350 Quantity
of Fish
Quantity
of Mangos
Quantity
of Fish
Price of
Fish
150
AB
150
$4A
350
B
49
A: When PF = $4, Hurley demands 150 fish.B: When PF = $2, Hurley demands 350 fish.
7/31/2019 Consumer Demand Theory (1)
50/58
THE THEORY OF CONSUMERCHOICE 50
Application 1: Giffen Goods
Do all goods obey the Law of Demand?
Suppose the goods are potatoes and meat,
and potatoes are an inferior good.
If price of potatoes rises, substitution effect: buy less potatoes
income effect: buy more potatoes
If income effect > substitution effect,then potatoes are a Giffen good, a good for which an
increase in price raises the quantity demanded.
Application 1:
7/31/2019 Consumer Demand Theory (1)
51/58
THE THEORY OF CONSUMERCHOICE 51
Application 1:
Giffen Goods
A li ti 2 W d L b S l
7/31/2019 Consumer Demand Theory (1)
52/58
THE THEORY OF CONSUMERCHOICE 52
Application 2: Wages and Labor Supply
Budget constraint
Shows a persons tradeoff between consumption andleisure.
Depends on how much time she has to divide between
leisure and working.
The relative price of an hour of leisure is the amount of
consumption she could buy with an hours wages.
Indifference curve
Shows bundles of consumption and leisure
that give her the same level of satisfaction.
A li ti 2 W d L b S l
7/31/2019 Consumer Demand Theory (1)
53/58
THE THEORY OF CONSUMERCHOICE 53
Application 2: Wages and Labor Supply
At the optimum,
the MRS betweenleisure and
consumption equals
the wage.
A li ti 2 W d L b S l
7/31/2019 Consumer Demand Theory (1)
54/58
THE THEORY OF CONSUMERCHOICE 54
Application 2: Wages and Labor Supply
An increase in the wage has two effectson the optimal quantity of labor supplied.
Substitution effect(SE): A higher wage makes leisure
more expensive relative to consumption.The person chooses less leisure,i.e., increases quantity of labor supplied.
Income effect (IE): With a higher wage,
she can afford more of both goods.She chooses more leisure,i.e., reduces quantity of labor supplied.
A li ti 2 W d L b S l
7/31/2019 Consumer Demand Theory (1)
55/58
THE THEORY OF CONSUMER
CHOICE 55
Application 2: Wages and Labor Supply
For this person, SE
> IE
So her labor supply
increases with the wage
A li ti 2 W d L b S l
7/31/2019 Consumer Demand Theory (1)
56/58
THE THEORY OF CONSUMER
CHOICE 56
Application 2: Wages and Labor Supply
For this person, SE
< IE
So his labor supply falls
when the wage rises
7/31/2019 Consumer Demand Theory (1)
57/58
THE THEORY OF CONSUMER
CHOICE 57
Could This Happen in the Real World???Cases where the income effect on labor supply is very
strong:
Over last 100 years, technological progress has
increased labor demand and real wages.
The average workweek fell from 6 to 5 days. When a person wins the lottery or receives an
inheritance, his wage is unchanged hence no
substitution effect.
But such persons are more likely to work fewer
hours, indicating a strong income effect.
CONCLUSION:
7/31/2019 Consumer Demand Theory (1)
58/58
CONCLUSION:
Do People Really Think This Way?
People do not make spending decisionsby writing down their budget constraints and
indifference curves.
Yet, they try to make the choices that maximize their
satisfaction given their limited resources. The theory is only intended as a metaphor for how
consumers make decisions.
It explains consumer behavior fairly well in many
situations and provides the basis for more advanced
economic analysis.