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Explanations of the
Demand Curve
& Consumer Choice
1
The Income and Substitution Effect combine to make
a consumer able and willing to buy more of a specific
good at a low price than at a high price.
Income effect is the impact on a consumer’s real
income of a change in the price of a product and
consequently the quantity of the produce demanded.
When the price of a good decreases, people
can buy more with the same income.
When the price of a good increases, people
need to buy less with the same income.
2
Substitution effect is the impact that a change in the
product’s price has on its relative expensiveness and
consequently on the quantity demanded.
When the price decreases, the good is less
expensive relative to other similar goods. We
substitute with the now lower priced good.
When the price increases, the good is more
expensive relative to other similar goods. We
substitute with the now lower priced good.
3
What is Utility?
The satisfaction or
enjoyment a person
obtains from
consuming a good
4
What is a Util?
A hypothetical unit used to
measure how much
utility a person obtains
from consuming a good
5
Marginal Utility
The change in total utility
a person derives from
consuming an additional
unit of a good
6
Total Utility
The total number of utils a
person derives from
consuming a specific
quantity of a good
7
TU and MU
Q
0
1
2
3
4
5
6
7
TU
0
10
18
24
28
30
30
28
MU
10
8
6
4
2
0
-2
8
Law of Diminishing Marginal
Utility
After a point, as more of a good
is consumed, the marginal
utility (MU) a person derives
from each additional unit
diminishes.
9
Total Utility
TU
Total Utility increases at a
diminishing rate, reaches a
maximum and then declines.
Quantity
10
Marginal Utility
Marginal Utility diminishes with
increased consumption, reaches
zero satisfaction and then
becomes negative.
MU
Quantity
11
T
o
t
a
l
U
t
i
l
i
t
y
TU
When Total Utility is at its peak,
Marginal Utility is zero.
Unit Consumed
M
a
r
g
I
n
a
l
U
t
I
l
I
t
y
Unit Consumed
Marginal Utility reflects the
change in total utility so it is
negative when Total Utility
declines.
Marginal Utility diminishes
with increased
MU
consumption, is zero where
total utility is at a
maximum, and is negative
when Total Utility declines.
12
Demand Curve
P
P1
P2
D
Q1
Q2
Q
13
Why does
MU = P
explain the downward
sloping demand curve?
14
If you are hungry for a
hot dog, how many hot
dogs will you buy?
Up to where MU
=P
15
Why?
Because if MU > P you
will buy another hot dog
If MU < P you will not
buy that last hot dog
16
At P1, consume to Q1, since
MU > P up to that point, at
P2, consume to Q2, etc.
P1
P2
MU
Q1
Q2
17
Consumer equilibrium
Now, think about how to
allocate income among 2
or more goods or
services!
18
Consumer equilibrium
condition
Purchase good X and good
Y in amounts such that
MU X = MU y
Px
Py
Why?
19
Utility-Maximizing Rule
—Consumer Equilibrium
The consumer’s money income
should be allocated so that the last
dollar spent on each product
purchased yields the same amount of
marginal utility.
The rational consumer must
compare the extra utility with its
added cost.
20
Units
First
Second
Utility-Maximizing with Income of $10
Product A $1
Product B $2
MU or utils
MU/$
MU or utils
10
10
24
8
20
8
MU/$
12
10
Third
Fourth
7
6
7
6
18
16
8
Fifth
Sixth
Seventh
5
4
3
5
4
3
12
6
4
6
3
2
MU of Product A =
MU of Product B
Price of A
Price of B
How many of A and how many of B? What is the
combinations of A and B that can be had with $10?
Answer: 2 units of A and 4 units of B
MU of Product A = MU of Product B
Price of A
Price of B
8 = 16
$1 = $2
9
21
Assume you are not in
equilibrium… say that
MU x > MU y
Px
Py
What would you do??
22
Purchase more of X (due to its
greater satisfaction per dollar),
and less of Y
But… more of X reduces
MUX and less of Y
increases MUY so we are
heading back to
equilibrium!!
23
For more than 2 goods,
the equilibrium condition
becomes…..
MUx/Px = Muy/Py = Muz/Pz
= …….for all goods
24
In other words, when is your
Total Utility maximized?
When the last dollar
spent on each good yields
the same marginal utility
25