Download Economics of Demand

AAEC 2305
Fundamentals of Ag Economics
Chapter 2
Economics of Demand
Objectives
 To gain an understanding:
• About the Law of Demand
• How an individual’s budget limits the goods
that can be purchased
• About “Utility” & how an indifference curve is
derived
• How a demand curve is determined by an
individual ‘s budget & taste & preferences
Objectives (Cont.)
• The basic concepts of elasticity of demand,
cross-price elasticity, and income elasticity
• The determinants of demand elasticity
Introduction
 In this chapter we will examine the
economic concepts of consumption &
demand.
 Factors affecting the consumption decision:
• How much money an individual has to spend
(budget)
• The scarce goods available in the marketplace &
their prices
• The individual’s taste & preferences
Law of Demand
 The law of demand states that, ceteris
paribus, the quantity of a product
demanded will vary inversely to the price of
that product.
• As the price of a commodity increases, the
quantity demanded of that product decreases.
• As the price of a commodity decreases, the
quantity demanded of that product increases.
Consumption & Utility
 Utility – the satisfaction derived from
consuming a product, good, or service
• Since utility is derived from the inherent
characteristics or qualities that make a
product desirable, utility may be objective or
subjective.
• T/F, it is unlikely that two individuals would
obtain the same level of utility (satisfaction)
from the same amount of a product.
Consumption & Utility
 Util - a hypothetical numerical
measurement of utility (used to represent
the satisfaction derived from consuming
products)
Marginal Utility
 Marginal Utility (MU) – addition to total
utility (TU) provided by the last unit of the
good consumed
• MU = Δ TU / Δ Consumption
MU is the utility provided by the last unit of
the good consumed
 MU is central to understanding
consumption decisions & the law of
demand.

Law of Diminishing Marginal Utility
 Law of Diminishing Marginal Utility - as
additional units of a good are consumed a
point is always reached where the utility
derived from each additional unit declines.
Example
Consumption Total Utility
(doughnuts)
0
0
24
1
42
2
52
3
56
4
56
5
55
6
45
7
Example (Cont.)
Consumption Total Utility
(doughnuts)
0
0
1
2
3
4
5
6
7
Marginal
Utility
>
24
>
18
>
10
>
4
>
0
>
-1
>
-10
24
42
52
56
56
55
45
Budget Constraint
 Budget – amount of money (from salary,
loans, dividends, etc.) available for
purchases in a given time period.
• We all have a limited amount of money to
use for consumption
• Our budget constrains or limits how
much we can buy
Budget Constraint
 Budget Constraint – price & availability of
goods in the market, along with the size of
the budget, place a constraint on
consumption.
 Budget and budget constraint are
represented by the budget line.
Budget Line
 Budget Line – a line indicating all
combinations of two goods that can be
purchased using all of the consumer’s
budget.
TB = (Pg1 * G1) + (Pg2 * G2)
Example
Assume TB = 30, Pg1 = 1, & Pg2 = 2
G1
G2
Total Expenditure
30
0
30
24
3
30
18
6
30
12
9
30
0
15
30
Budget Line
 Every combination of goods along the
budget line can be purchased for the same
total expenditure.
 The distance from the origin is an
indication of the size of a the budget.
• The closer to the origin, the lower the budget
and vice versa.
Budget Line
 Only purchases on the budget line use all of
the consumer’s budget.
 The utility maximizing combination - where
consumption is optimum - lies somewhere
on the budget constraint.
Effects of Budget Changes
 A budget increase will result in a parallel
shift of the budget line to the right
 Conversely, a budget decrease will result
in a parallel shift of the budget line to the
left.
 Ex. of a budget increase
Effects of a Price change
If the price of one good changes,
slope of budget line changes
Ex. of price change
Indifference Curves
 Indifference Curve (IC) - a line showing all
combinations of two goods (products) that
provide the same level of utility
 T/F, each combination of products along
the IC provides the same level of utility
• i.e., the consumer is indifferent between them
Indifference Curves
G1
(Tacos)
25
19
14
10
7
5
Each combination of goods
G2
provides the same level of
(Sandwiches) utility.
5
 The downward slope of the IC
6
indicates that if the consumer
8
gives up one good, the
11
resulting loss in utility must be
15
compensated for by
consuming additional units of
20
the other commodity for utility
to remain constant.

Indifference Curves
 Since each IC represents a unique level of
utility, an IC exists for each level of utility a
consumer is capable of experiencing.
 T/F, the distance from the origin indicates
the level of utility
 T/F, each IC represents a unique utility
level - - Hence, IC can never intersect
 Additionally, the whole set of IC is called an
indifference map.
Indifference Curves
 As we move along the IC the utility level
remains the same but quantities of goods
consumed change as one good replaces (or
substitutes) for the other.
 Marginal rate of substitution (MRS) - rate one
good must or can decreased as consumption
of the other good increases
• i.e., rate at which one good can physically
substitute for another in the consumption
process
Marginal Rate of Substitution
 MRS is the slope of the indifference curve.
 Marginal Rate of Substitution of G2 for G1
(MRSG2G1) = G1 / G2 = replaced / added
 MRSG2G1 = G1 / G2 = MUG2 / MUG1
Marginal Rate of Substitution
G1
G2
25
5
MRSG2G1
-6
19
6
-2.50
14
8
-1.33
10
11
-0.75
7
15
-0.40
5
20
Possible MRS Relationships
 Imperfect Substitutes – diminishing MRS;
one good can be exchanged for another,
but at a decreasing rate.
 Perfect (Constant) Substitutes – constant
MRS; one unit of a good can be exchanged
for another on a constant basis.
 Perfect Complements – Fixed Proportions;
goods must be consumed in a fixed ratio
Consumer Choice Problem
 The basic problem a consumer faces is
how to allocate the budget among various
goods to maximize utility (satisfaction).
 A rational consumer maximizes utility by
consuming as many goods as desired,
within the limits imposed by the budget.
• i.e. - the consumer buys goods that provide the
most utility per dollar spent.
Utility Maximization Decision
Obj. of the consumer is to find the combination of
goods that provides the maximum amount of
utility for his/her given budget (income).
 T/F, the consumer wants to reach the highest
possible level of utility, given their budget
constraint.
 I.e., consumer wants to find tangency between the
highest possible indifference curve (utility) and
the budget line (budget constraint).

Utility Maximization Decision
 Tangency occurs where slope of the
indifference curve equals the slope of the
budget line.
 MRSG2G1 = IPR
 G1 / G2 = PG2 / PG1
 Can be viewed as:
(G1 * PG1) = (G2 * PG2)
“Budget Savings” = “Budget Expenditures”
Utility Maximization Decision
G1
G2
25
5
19
14
10
7
5
G1
G2
MRSG1G2
G1*PG1
G2*PG2
IPR
-6
1
-6.00
-6
2
-2
-5
2
-2.50
-5
4
-2
-4
3
-1.33
-4
6
-2
-3
4
-0.75
-3
8
-2
-2
5
-0.40
-2
10
-2
6
8
11
15
20
Utility Maximization Decision
 Recall –
 MRSG2G1 = G1 / G2 = MUG2 / MUG1
 We can specify (MRSG2G1 = IPR) as:
MUG2 / MUG1 = PG2 / PG1
MUG2 / PG2 = MUG1 / PG1
* Utility max occurs where MU per dollar spent is
equal for the two goods.
Impact of Changes in Product Prices
 IF PG2 increases-
• G2 becomes relatively more expensive than G1
• The slope of the budget line increases and the
budget line rotates inward
• The consumer can no longer afford to remain
on original indifference curve and must reduce
consumption
• T/F, the consumer will consume less of G2 and
more of G1.
Impact of Changes in Product Prices
 IF PG2 decreases-
• G2 becomes cheaper relative to G1
• The slope of the budget line decreases and the
budget line rotates outward
• The consumer can afford to move to a higher
indifference curve and can increase
consumption
• T/F, the consumer will consume more of G2 and
less of G1.
Deriving a Demand Curve
Demand Schedule – information on price and
quantity (consumption) combinations that give
the consumer maximum utility, ceteris paribus.
 Demand Curve – a line connecting all
combinations of price and quantities consumed
• Each point on a demand curve gives the price
and quantity combination of a good that a
consumer will buy, given his or her budget
constraint and the prices of other goods.

Demand Curve
 The demand curve slopes downward and to
the right.
 Each point on the demand curve gives a
quantity of the good that a consumer will
buy to maximize utility.
 Refer to class example on how to derive a
demand curve.
Elasticity of Demand (ED)
 Elasticity of demand is defined as the
percentage change in the quantity
demanded relative to a percentage change
in the price as we move from one point to
another on a demand curve.
 Elasticity of demand represents movement
along the demand curve and thus elasticity
is also a measure of the degree of slope of
the demand curve.
Elasticity of Demand (ED)
 Mgrs. & Economists are interested in two
types of demand elasticity measures:
• Own-price elasticity: measures the
responsiveness of the quantity demanded of a
good to changes in the price of that good.
• Cross-price elasticity: measures the
responsiveness of the quantity demanded of a
good to changes in the price of a related good.
Own-Price Elasticity of Demand
 The own-price elasticity of demand is
calculated as follows:
 ED = %  QD
/ %P
<or>
 ED = ((Q2-Q1)/(Q2+Q1)) / ((P2-P1)/(P2+P1))
Classifications of Own-Price
Elasticity of Demand

Classifications:
• Inelastic demand ( |E| < 1 ): a change in price
brings about a relatively smaller change in
quantity.
• Unitary elastic demand ( |E| = 1 ): a change in
price brings about an equivalent change in
quantity.
• Elastic demand ( |E| > 1 ): a change in price
brings about a relatively larger change in
quantity.
Cross Price Elasticity of Demand
 ED
=
((Q
–
Q
)
/
(Q
+
Q
))
/
((P
–
P
)
/
2A
1A
2A
1A
2B
1B
AB
(P2B + P1B))
 Shows the percentage change in the
quantity demanded of good A in response
to a change in the price of good B.
 Read as the cross-price elasticity of
demand for commodity A with respect to
commodity B.
Classification of
Cross-price elasticity of Demand
Substitutes in consumption (EDAB > 0): implies
that as the price of good B increases, the quantity
demanded of Good A by the consumer also
increases (& vice versa).
 Complements in consumption (ED < 0): implies
AB
that as the price of good B decreases, the quantity
demanded of Good A by the consumer also
increases (& vice versa).
 Independent in consumption (ED = 0): implies
AB
that the price of good B has no effect on quantity
demanded of Good A.

Income Elasticity of Demand (EDI)
 Since a demand curve represents
the
amount at each price that consumers are
WILLING and ABLE to purchase, the amount
of income available to consumers has a
direct effect on their effective demand.
 If consumer’s income increases
(decreases), the position of the demand
curve will also change (shift).
Income Elasticity of Demand (EDI)
 The direction of the shift depends on if the
good is a normal or inferior good.
• Normal good (aka as superior good)– demand
increase with income (& vice versa)
• Inferior good – demand decreases with
increases in income (& vice versa)
Income Elasticity of Demand (EDI)
 ED
=
%

Q
/
%

I
<or>
D
I
 ED = ((Q2-Q1)/(Q2+Q1)) / ((I2-I1)/(I2+I1)
I
 If ED
>
0,
then
the
good
is
considered
a
I
normal good.
 If ED < 0, then the good is considered an
I
inferior good.
Engel’s Law
 The percentage of total income spent on
food generally declines as income
increases resulting in an income elasticity
of demand for the total quantity of food less
than one, a relationship known as Engel’s
Law.