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Chapter 3; Consumer Behaviour,
Demand and Elasticity
Learning Outcomes:
Understand the relationship between consumer
demand and output decisions
Relate the concept of satisfaction and demand
for consumer goods
Identify and analyse equilibrium in consumer
demand
Appreciate how price elasticity of demand
influences price and output decisions
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Utility
• Utility is the satisfaction derived from the
consumption of a good measured in numbers.
• This analysis of consumer demand is based on
the presumption that the amount of utility
generated from the consumption of a good can
be explicitly measured."
• Marginal utility is the additional utility derived
from consuming each additional unit of the
good.
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Total and Marginal Utility
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The Law of Diminishing Marginal Utility
• The law of diminishing marginal utility states
that marginal utility, or the extra utility obtained
from consuming a good, decreases as the
quantity consumed increases. In essence, each
additional good consumed is less satisfying than
the previous one.
• If each additional unit of a good is less
satisfying, then a buyer is willing to pay less. As
such, the demand price declines.
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Indifference Curves
• Here we look at the analysis of the indifference
curves. This curve suggests that a consumer
will be "indifferent" between consuming any
combination of the two goods anywhere on the
curve.
• Indifference curve analysis relies on a relative
ranking of preferences between two goods
rather than the absolute measurement of utility
derived from the consumption of a particular
good..
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An Indifference curve
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Demand and Elasticity
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Demand
Demand is the willingness and ability to buy a
range of quantities of a good at a range of
prices, during a given time period.
The following factors affect demand
The price of the good and substitutes
Consumers’ disposable incomes
Advertising of this product
Rates of interest.
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Demand Curve
• The demand curve is a graphic representation
of the market demand function and the Law of
Demand. The demand curve represents the
quantities of a good or service that consumers
are willing and able to purchase at various
prices.
• The demand curve slopes down from left to right
based on the Law of Demand. As the price of
good increases, consumers switch purchases to
other goods, reducing the quantity demanded.
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The Demand Curve
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Price Elasticity of Demand
• The law of demand mentioned above states that
when a price of that product changes it causes
an inverse change in the amount of quantity
demanded of that good, ceteris paribus.
• The theory of elasticity states the approximated
magnitude of how much change in demand will
occur given a percentage change in its price
level. Therefore the price elasticity of demand
can be referred to as the percentage change in
quantity demanded of a good due to a one
percent change in its price level.
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Formula
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Interpretation
If elasticity is greater or equal to one, the
demand curve is considered to be elastic.
If it is less than one, the demand curve is said to
be inelastic.
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Elasticity and Revenue
• The theory of demand suggests that when a
firm tries to maximise revenue but not operating
at the midpoint of its demand curve should raise
price if demand is inelastic and should lower
price if demand is elastic.
• If demand is inelastic, customers are not
responsive. However, if demand is elastic,
customers are very sensitive.
• Hence, as a manager, you should raise price
only when demand is inelastic which means you
are to the right of the demand curve midpoint.
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Note these Points
• Any revenue changes in response to price
changes will depend upon elasticity.
• When elasticity is greater than one price
changes and revenue changes are inverse.
• When elasticity is less than one, price changes
and revenue changes are direct.
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Income Elasticity of Demand
• Income elasticity of demand is referred to as the
ratio that measures the relative responsiveness
of demand due to a change in the income of
consumers.
• Income Elasticity of Demand
• = % change in Qd / % change in Price
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Income elasticity of demand
• Income elasticity of demand is used to see how
sensitive the demand for a good is to an income
change. The higher the income elasticity, the
more sensitive demand for a good is to income
changes. A very high income elasticity suggests
that when a consumer's income goes up,
consumers will buy a great deal more of that
good. A very low price elasticity implies just the
opposite, that changes in a consumer's income
has little influence on demand.
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Income elasticity of demand
• If income elasticity of demand is greater than
one, demand for the product is considered to
have high income elasticity. If however income
elasticity is less than one, demand is considered
to be income inelastic.
• Luxury items usually have higher income
elasticity because when people have a higher
income, they don't have to forfeit as much to
buy these luxury items.
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Income elasticity of demand
• With some goods and services, we may actually
notice a decrease in demand as income
increases. These are considered to be inferior
goods and will be dropped by a consumer who
receives a salary increase. ( e.g)
• Products for which the demand decreases as
income increases have an income elasticity of
less than zero. Products that witness no change
in demand despite a change in income usually
have an income elasticity of zero. These goods
and services are considered necessities.
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Cross-Price Elasticity of Demand
• The Cross-Price Elasticity of Demand measures
the rate of response of quantity demanded of
one good, due to a price change of another.
• If two goods are substitutes, we should expect
to see consumers purchase more of one good
when the price of its substitute increases.
• Similarly if the two goods are complements, we
should see a price rise in one good cause the
demand for both goods to fall.
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Cross-Price Elasticity of Demand
The cross price elasticity of demand can be
measured as follows:
• Cross Elasticity of demand =
• percentage change in Qd for Good X
• percentage change in price of Good Y
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Market Supply
• Supply reflects the behaviour of producers. The
supply curve indicates the quantities of a good
or service that firms are willing to produce at
different price levels, ceteris paribus. The law of
supply states that any increase in the price level
will lead to an increase in the quantity supplied
of goods and services, all other things
remaining equal. Hence, there exists a positive
relationship between the price level and quantity
supplied implying the supply curve is an
upward-sloping curve.
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Movements along the Supply Curve
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Improved Technologies
• Suppose advanced transport technologies and
innovations are introduced in the production of
motorcars, all other things remaining constant..
• An increase in technology will lead to increased
production, and hence shifts the supply curve to
the right.
• Alternatively, increases in wages, which forms
part of a firms costs of production will cause the
supply curve to shift to the left at each price
level.
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Shifts in the Market Supply Curve
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Market Equilibrium
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Increased Demand and Equilibrium
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Decreased supply and equilibrium
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End of Chapter 3
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