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MICROECONOMICS TOPIC 2 Economics 2013-14 DEMAND UTILITY Consumers get satisfaction from goods and services. In economics this is called UTILITY. Three ways to measure utility are: How people react when consuming How much of the product they consume The price they are willing to pay. UTILITY Total utility is the total satisfaction a consumer will get from consuming a product over a period of time. Marginal utility is the satisfaction gained from consuming an extra unit of a product. Total utility is the total of the marginal utilities gained from each unit consumed. DIMINISHING MARGINAL UTILITY As someone consumes more of a product the utility gained from each extra unit decreases. Total utility will continue to increase but at a slower rate, until a maximum is reached. At this point there is no more satisfaction to be gained from consuming more of the product. Marginal utility will be zero. EXAMPLE PINT OF BEER MARGINAL UTILITY TOTAL UTILITY First £2.00s worth £2.00s worth Second £1.80s worth £3.80s worth Third £1.50s worth £5.30s worth Fourth £1.10s worth £6.40s worth If price was £2.00 the consumer would be willing to buy 1 pint because he gets £2 worth of satisfaction. If the price was £1.80 he would be willing to buy 2 pints. He gets £2 worth of utility from the first pint and £1.80’s worth from the second. The information can be shown as a demand schedule. This shows how much a consumer would be willing to buy at a range of prices. Price Quantity Demanded £2.00 1 £1.80 2 £1.50 3 £1.10 4 CONSUMER SURPLUS This is the difference between how much a consumer would be prepared to pay and what is actually paid. If the price of beer was £1.80 a pint, the consumer would buy 2 pints. He was prepared to pay £2 for the first pint so he gets 20p of utility free, a consumer surplus of 20p RATIONAL CONSUMER BEHAVIOUR Economists believe that consumers act in a rational way. This means they want the best value for money. Not always possible due to: imperfect knowledge Action of other people Lack of self-control. Assuming rational behaviour, a consumer will achieve maximum utility when the marginal utility spent on the last unit of each good is equal This is called EQUI-MARGINAL RETURNS Demand 1. 2. Demand (or effective demand) is the quantity of a good or service which a consumer is ABLE and WILLING to buy at a particular price over a certain period of time. Two types of demand exist: INDIVIDUAL DEMAND – this is demand of one person for a product. MARKET DEMAND – this is all the individual demand added together. THE LAW OF DEMAND The Law of Demand states: that as the price of a product increases the demand for it will fall. This happens for two reasons: 1. 2. INCOME EFFECT – as the price of a product increases then a person’s real income falls. They are not ABLE to buy the same amount. SUBSTIUTION EFFECT – as the price of a product increases people will swap to goods that are close to the original product. They are less WILLING to buy. DEMAND CURVES The demand curve slopes downward from left to right. It shows that as price increases the quantity demand falls and vice versa. PRICE D TYPICAL DEMAND CURVE P1 P D Q1 Q QUANTITY EXCEPTIONS TO THE LAW OF DEMAND These are goods or services where demand rises as price increases. Goods of prestige, e.g. designer goods Assumption of a link between price and quality – higher the price the better the quality. Expectation of future price rises, e.g. buying shares. Giffen goods – highly inferior goods, e.g. rice and potatoes. PRICE EXCEPTIONS DEMAND CURVE QUANTITY The demand curve for the exceptions to the Law of Demand will slope upwards to begin with. Eventually though it will resume the normal shape as the income effect kicks in. IT IS IMPORTANT TO REMEMBER THAT WHEN IT IS PRICE THAT CHANGES IT IS A MOVEMENT ALONG THE DEMAND CURVE. INCREASE IN PRICE IS A CONTRACTION IN DEMAND. DECREASE IN PRICE IS AN EXTENSION IN DEMAND. DEMAND IS SAID TO HAVE RISEN BUT NEVER INCREASED! CONDITIONS OF DEMAND CETERIS PARIBUS - This is Latin for other things remaining the same. It means that in Economics there is only ever one changing variable at a time. Price is only one factor that might change the demand of a product, in reality there are many other factors. OTHER CONDITIONS OF DEMAND Disposable Income demand for normal goods/inferior goods Other goods price goes up for one/effect on another e.g. Tea/Coffee Effects on complimentary goods e.g. strawberries and cream Population Changes effects demand e.g. age Tastes and preferences fashionable goods; advertising campaign effects EFFECT ON THE DEMAND CURVE When it is a condition of demand, the demand curve will either shift to the left (decrease in demand) or shift to the right (increase in demand). REMEMBER CETERIS PARIBUS. If it is a condition of demand price stays the same. ELASTICITY OF DEMAND Two types exist: Price elasticity Income elasticity PRICE ELASTICITY OF DEMAND This measures how responsive demand is to a change in price. Measures how consumers react to the change of the price of a product. FORMULA: PED = % change in demand % change in price ANSWERS If PED is greater than 1, demand is very responsive to a change in price. Demand is PRICE ELASTIC If the PED is less than 1, demand is not responsive to a change in price. Demand is PRICE INELASTIC. If PED is 0, demand hasn’t changed, then demand is PERFECTLY INELASTIC. If PED is equal to infinity, demand has changed without a change in price, the demand is PERFECT ELASTIC. If PED is equal to 1, then demand has UNITARY ELASTICITY. IMPORTANCE OF PRICE ELASTICITY Firms really need to know about the elasticity of demand as it helps determine whether they should increase or decrease its prices. Government need to know about it to determine whether to increase or decrease taxation. PRICE ELASTIC DEMAND When demand is price elastic it would be better for the firm to decrease the price. Elastic demand means that even when there is a small change in price there is a big change in demand. If the firm was to increase the price the revenue gained from the increase in price would be less than the revenue lost as a result of the drop in demand. PRICE ELASTIC DEMAND DIAGRAM D P1 Revenue Gain P D Revenue Loss Q1 Q PRICE INELASTIC DEMAND In this situation the firm would increase the price. Inelastic demand means that even when there is a big change in price there is only a small change in demand. The revenue lost from the small change in demand is outweighed by the revenue gained from the change in price. So total revenue will increase. PRICE INELASTIC DEMAND DIAGRAM D P1 Revenue Gain P D Revenue Loss Q1 Q FACTORS AFFECTING PRICE ELASTICITY OF DEMAND Availability of substitutes – a product with a lot of substitutes will have elastic demand e.g. Nescafe. Price relative to total spending – e.g. matches Habit – any product that a consumer considers to be a necessity, then demand will be price inelastic. e.g. Petrol Fashion – goods which are highly fashionable would be price inelastic e.g. IPhone Frequency of purchase – products bought regularly would have price inelastic demand e.g. Milk INCOME ELASTICITY OF DEMAND This measures the responsiveness of demand to changes in income. FORMULA: IED = % change in demand % change in income ANSWERS When a person’s income increases by 10% it does not mean that they will buy 10% more than before. Some commodities will still be unaffordable – 0 income elasticity Some products they will be no more or no less of e.g. newspaper – 0 income elasticity Some products they may only buy a little more of, e.g. food. These have income inelastic demand. Some goods and services they will buy a lot more of, e.g. nights out. These have income elastic demand. ANSWERS Both income elastic and income inelastic demand are said to have POSTIVE INCOME ELASTICITY Some products the consumer will buy less of, inferiors goods such as own brands. These have NEGATIVE INCOME ELASTICITY. IMPORTANCE OF INCOME ELASTICITY If a seller knows the income elasticity of their products they can predict what would happen to their products if incomes changed and how this would affect their revenue. Also helps the government predict changes in revenue from taxes on products.
