Download `Module 3 - Demand 3.1 Introduction Households try to maximize

‘Module 3 - Demand
3.1 Introduction
 Households try to maximize utility subject to a budget constraint
 Firms try ot maximize profit by hiring resources to produce the goods and services consumers want
most
 For the purposes of this discussion, household = individual
3.2 The Theory of Consumer Choice
 Households will change their expenditure pattern until it maximizes its utility
 That occurs when the utility from the last dollar spent on any good or service just equals the utility that
would be received from the last dollar spent on any other good or service
 Marginal utility is the extra utility derived from consuming an additional unit of a good
 Marginal utility decreases as the consumption of a good increases – this is the Law of Diminishing
Marginal Utility
 Diminishing marginal utility means that an individual can increase total utility by purchasing a
combination of goods and services rather than by allocating the budget to one good only
 Total utility can be increased by switching expenditure from goods with low marginal utility to those with
high until the marginal utility from one equals the other
 What if one good (A) is twice as expensive as another (B) – how do we maximize total utility then? In
this case the last unit of good A consumed has to yield twice the level of utility of the last unit of good B
consumed. Put another way:
To maximize total utility:
Marginal Utility of Good A = Marginal Utility of Good B = ….Marginal Utility of Good Z
Price of Good A
Price of Good B
Price of Good Z
or:
MUa = MUb = …=MUz
Pa
Pb
Pz
If
MUa > MUb
Pa
Pb
to increase total utility he should buy more of Good A and less of B, the law of diminishing returns will
them reduce MUa and increase MUb until:
MUa = MUb
Pa
Pb
Example:
You have $10 to spend on Wine at $1/glass and salmon sandwiches ar $0.50 a sandwich. To maximize
utility, the last glass of wine must yield twice the utility of the last salmon sandwich.
 Both income (budget) and prices effect the quantities of goods that you buy
3.3 Individual (or Household) Demand
 The quantity of a particular good that an individual buys depends on many factors e.g. its price, price of
alternatives, income etc.
 To isolate and measure the influence of any factor on potential purchases of a particular good, its
necessary to hold constant all other factors affecting the purchase of that good – this is what we do to
measure demand
 cet. par. is the latin term for keeping things equal or the same
 The individual demand for a good is the relationship between the price of a good and the quantity of a
good that an individual would be willing to buy in a given time period
 A demand curve shows a hypothetical relationship concerning what our individual would be preapared
to buy at each price, at each time period. cet. par – it ignores other factors that may effect demand e.g.
the price of substitute goods
 Demand curve typically is negatively inclined to the price axis (lower prices mean higher quantities)
because of a combination of two factors:
- at a higher price, a constrained budget or income results in fewer unit sold (income effect).
- at a higher price, an individual substitutes relatively cheaper goods (substitution effect)
 A price rise lowers an individuals total utility because he buys less of that good ie. a loss of Real
income
 Similarly, a reduction in money income (budget) results in a loss of total utility
Example:
A household buys chicken as well as meat and fish. If the price of chicken reduces then more chicken is
bought not only because real income has risen but also because it will be substituted for the relatively
more expensive foods such as steak.
 Substitution effect is always negative, because a price increase means a decrease in quantity
purchased as cheaper goods are substituted for it
 Income Effect is positive for normal goods, i.e. an increase in real income due to an increase in budget
or a decrease in price will lead to an increase in demand for a normal good
 So for normal goods the negative substitution effect re-inforces the positive income effect, causing the
downward demand curve
 An inferior good is one for which the quantity purchased falls when real income rises i.e. the income
effect is negative for inferior goods
 An increase in real income could be caused by an increase in money income (budget) while all prices
remain constant, or by a decrease in prices where money income remains fixed
 The substitution effect normally outweighs the income effect, and so even for inferior goods, the
demand curve slopes down
Example:
Margarine is an inferior good, if the price of margarine falls then more households use it instead of butter
thus causing an increase in real income. This may result in some households switching back to butter, but
not enough to outweigh the original substitution effect.
 A Giffen good is one in which a large income effect outweighs the substitution effect – e.g. in 19th
century Ireland the price of potatoes fell causing an increase in real income. Potatoes (the cheaper
good) were substituted for other more expensive vegetables. So the drop in the price of potatoes
caused less potatoes to be purchased
 In the demand curve, price is the independent variable, quantity the dependent variable and all the
other factors that influence both (which are kept constant) are termed parameters
 Shift in parameters like a households taste, preference or income causes a shift in the demand curve
 How does the demand curve relate to utility maximization?
Lets say you are in equilibrium (i.e. maximizing utility) in a two good (wine and sandwiches) world
MUw = Mus
Pw
Ps
lets presume that at thos prices MUw = Mus =
Pw
Ps
Wine reduces to $0.50 per glass =>
4
1
MUw = 8
Pw
1
So the last $1 spend on wine now yields twice as much utility as you can buy two glasses instead
of one. The net gain in utility in buying wine rather than sandwiches is 4 (8-4). You continue to
reallocate your resources to wine until once more
MUw = Mus
Pw
Ps
Hence the demand curve for wine will be negatively inclined to the x axis
 The individual demand for any product can be assumed to have a negligible influence on both price
and quantity bought and sold for that good – total market demand however does
3.4 Market Demand
 The Market Demand for a good is the sum of demands for that good of the individuals who comprise
the market
 A Market Demand curve is derived from individual demand curves
3.4.1 Price Inelasticity
 A good is price-inelastic when, as price changes, the proportional change in the quantity demanded is
less that the proportional change in price
 With P = initial price and Q = initial quantity:
Q < P
Q
P
 If E is a measure of price Inelasticity then:
E= Q/Q <1 (normally ignore the negative sign that is caused by price and quantity moving in
P/P
opposite directions)
 So if a price change from $1 to $1.10 results in a quantity change from 100 to 80, the elasticity is:
E= Q/Q = 20/100 = .2/.1 = 2
P/P
.1/1
 So if a price change from $1.10 to $1.0 results in a quantity change from 80 to 100, the elasticity is:
E= Q/Q = 20/80 = 2.75
P/P
.1/1.1
3.4.3 Unitary Price Elasticity
 A good has unitary price elasticity when, as price changes, the proportional change in the quantity
demanded exactly equals the proportional change in price
 So, in this case total expenditure remains the same whether it’s a price increase or decrease
 In the last two example in the previous section we saw how the price elasticity varied depending on
whether there was a price increase or decrease – this normally is insignificant if the good is elastic or
inelastic
 In the case of unitary elasticity, however, this may have a significant effect hence we should use a
different formula:
E’ = (Q1-Q2)/((Q1+Q2)/2)
(P1-P2)((P1+P2)/2)
 So if a good’s price increased from $0.8 to $1 caused a decrease in quantity from 125 to 100
E’ = (25)/225/2 = 0.22/0.22= 1
0.2/1.8/2
What happens if the opposite happens, a price decrease:
E’ = 1 as well
3.4.4 Variation in price elasticity of Demand
Price
20
E=Infinity
E>1
E=1
E<1
E=0
100
Quantity
 The E= infinity is because any in the equation for E, the Q will be zero and hence dividing by zero
gives infinity
 The above figure shows that even with a straight line demand curve, the value of E moves from infinity
all the way to 0 as you move left to right
 The are three types of demand curve where E remains constant
- Perfectly inelastic (demand curve is a vertical line)
- Perfectly elastic (demand curve is a horizontal line)
- Unitary elasticity (shown below)
Price
E=1, all the way
around the curve
Quantity
Note: the price elasticity of demand does not directly relate to the steepness of the curve, because the
scales on the axes could differ
 Goods which are necessities are usually price inelastic, as are goods which account for a small
proportion of an individuals budget (e.g.stamps)
 goods which have close substitutes are usually price elastic
3.4.5 Other Elasticities of Demand
 Cross elasticity of demand is a measure of how a price change in one good can effect the quantity
demanded of another:
Qa/Qa
this varies from minus infinity to plus infinity
Pb/Pb
 Complementary goods have negative cross elasticity
 Subsitute goods have a positive cross elasticity
 Income elasticity is the measure of how much quantity demanded changes as income change cet. par.
Income elasticity = Q/Q
Income/Income
 There are five important values for income elasticity
- negative, demand for a good decreases as income increases e.g. inferior goods like cheap
meat
- zero, no change
- between 0 and 1, quantity increase is proportionally smaller than income increase
- 1, both are proportional
- >1, quantity demanded increases more than income e.g. housing
3.5 The Theory of Consumer Behavior and the Real World
 Important to companies to know what the likely demand for their products will be
 First step – identify the characteristics of the type of people who consume the product e.g.
demographics, likes, dislikes
 Then estimate the elasticities mentioned in previous section
 Collect and analyze the data to determine if the demand curve will be shifting right or left or remain as it
is
 Predicting demand is difficult as external factors may effect the demand curve e.g. worldwide recession
 Govt also wants to know the demand for services and taxes
 When taxes are high
- it effects households disposable income
- it also effects work effort
 Taxes on goods and services effect the distribution of real income
Review Questions
1. b
2. a
3. b
4. b
5. d
6. a
7. c
8. c
9. c
10. c
11. b
12. c
13. a
14. a