Download The Demand For Goods and Utility Maximization

Chapter-5
The Demand for Goods
In This Chapter….
5.1. Why is demand curve downward
slopping?
5.2. How to measure behavioral responses of
consumers to changes in determinants of
demand (Elasticity)?
5.3. The Effect of Elasticity on the Revenue of
the Producer (Seller).
5.3. How Consumers Allocate their Income
Among Competing Ends?
5.1. What Explains the Consumer
Behavior?
 What determines what we buy? How
we buy?
 What leads us to buy some goods
while rejecting others?
 Why do we buy more at lower prices
and less at higher prices?
5.1.What Explains the
Consumer Behavior?
Two Explanations
 The Sociopsychiatric Explanation
 The Economic Explanation
5.1.What Explains the
Consumer Behavior?
1. The Sociopsychiatric Explanation
 In Freud’s view, higher levels of
consumption satisfy our basic drives for
security, sex, and ego gratification.
 According to sociologists, consuming more
is an expression of identity that provokes
recognition or social acceptance.
5.1. What Explains the Consumer
Behavior?
 The Economic Explanation
 In explaining consumer behavior,
economists focus on the demand for
goods and services.
 Demand is the willingness and ability to
buy specific quantities of a good at
alternative prices in a given time period,
ceteris paribus.
The Economic Explanation
 An individual’s demand for a product
is determined by:
– Tastes—desire for this and other goods.
– Income—of the consumer.
– Expectations—for income, prices, tastes.
– Other goods—their availability and prices.
The Economic Explanation
 Economists use the Demand Curve to Explain
the consumer behavior… how consumer
tastes affect consumption decisions.
 Law of demand: Ceteris paribus, individuals buy
less quantities, when prices are higher and more
quantities when prices are lower.
 They do so because they have a goal of
getting maximum Possible Satisfaction
(Pleasure) from their limited resources.
 Utility
The Economic Explanation
 Utility is the pleasure or satisfaction
obtained from a good or service. Utility
Theory
 Measuring Utility (Satisfaction)
 Cardinal Units (absolute numbers
indicating levels): Utils
 Ordinal Unity (Rankings, Orders of
preferences)
The Economic Explanation
 Total Utility is the amount of satisfaction
obtained from entire consumption of a
product.
 The more we consume of a product the more
utility (satisfaction) we obtain. I.e., More is
Preferred to Less!
 Thus the more pleasure (utility) a product
gives us, the higher the price we’re willing to
pay for it.
The Economic Explanation
 However, more is not always
and necessarily better.
Two Distinct Levels of Satisfaction:
1. Total Utility
2. Marginal (additional) Utility
The Economic Explanation
 Total Utility :
 the amount of satisfaction obtained from the
entire consumption of a product.
 Marginal utility:
 the change in total utility obtained by
consuming one additional (marginal) unit of
a good or service.
change in total utility
Marginal utility =
change in quantity
The Economic Explanation
 There is a natural limit to how much more...
TOTAL UTILITY
Total Utility
Total utility
0
1
2
3
4
5
Quantity of Popcorn
(boxes per show)
6
The Economic Explanation
 Although we prefer more to less, more is not
always and necessary better …
 Human Behavior:
 When we have more and more of some thing we
start to value it less and less. We do so…
 The additional satisfaction we get from consuming
one more unit of the same product is lower than the
level of satisfaction we obtain from consuming earlier
units of the product.
 Declining Marginal Utility
The Economic Explanation
MARGINAL UTILITY
TOTAL UTILITY
0
1
2
3
4
5
Quantity of Popcorn
(boxes per show)
6
Marginal Utility
Total Utility
Total utility
Negative
marginal
utility
0
1
2
3
4
5
Quantity of Popcorn
(boxes per show)
6
Diminishing Marginal Utility
 According to the law of diminishing
marginal utility, the marginal utility
of a good declines as more of it is
consumed in a given time period.
 As long as marginal utility is positive,
total utility must be increasing.
Diminishing Marginal Utility
 According to the law of diminishing
utility, each successive unit of a good
consumed yields less additional
utility.
 Eventually, additional quantities of a
good yield increasingly smaller
increments of satisfaction.
 Downward slopping Demand Curve
The Economic Explanation
Implication…
 Our consumption decision is guided by
not by how much total satisfaction we
get, but by how much additional
satisfaction we get when consuming
one more unit of a product
The Economic Explanation
Demand Curve: Price and Quantity relationship (Why is it
downward slopping?)
 Tastes, through marginal utility, tells us how much we
desire particular goods.
 Price tell us how much of a good we will buy.
 The more marginal utility a product delivers, the more a
consumer is willing to pay, ceteris paribus.
 As the marginal utility of a good diminishes, so does our
willingness to pay.
5.2. Gagging Responses to Changes
in the Determinants of Demand
5.2. Gagging Responses to Changes
in the Determinants of Demand
 According to the law of demand, the
quantity of a good demanded in a
given time period increases as its
price falls, ceteris paribus.
 (Own Price, Income, Price of other
Products,….)
5.2. Gagging Responses to Changes
in the Determinants of Demand
 Elasticity
 A measure of the responsiveness (the
sensitivity) of consumers (buyers) –in
terms of the quantities they buy, to
changes in the determinants of demand
(Own Price, Income of the Consumer,
Price of Other Goods, etc)
5.2. Gagging Responses to Changes
in the Determinants of Demand
 Elasticity
 Price Elasticity of Demand
 Income Elasticity of Demand
 Cross Price Elasticity of Demand
Price Elasticity (E)
 The price elasticity of demand is
the percentage change in quantity
demanded divided by the percentage
change in price.
 Is a measure of the response of
consumers to a changes in own price of
a product.
Individual’s Demand Schedule
and Curve
Quantity Demanded
A
0.50
1
B
0.45
2
C
0.40
4
D
0.35
6
E
0.30
9
F
0.25
12
G
0.20
16
H
0.15
20
I
0.10
25
J
0.05
30
$0.55
A
0.50
The willingness to pay
B
diminishes along with
0.45
C marginal utility
0.40
D
0.35
E
0.30
F
0.25
G
0.20
H
0.15
I
0.10
J
0.05
PRICE (per ounce)
Price
0 4 8 12 16 20 24 28 32
Quantity Demanded (Ounces per show)
Computing Price Elasticity (E)
Percentage change
in quantity demanded
Price elasticity =
percentage change in price
Computing Price Elasticity
 To ensure consistency,…
 average quantity and average price
(before and after) is used in the calculation
of Elasticity.
Percentage change
Change in quantity
=
in quantity demanded
Average quantity
Change in quantity
Percentage change in price =
Average quantity
Computing Price Elasticity
Q 2  Q1
P 2  P1
E

( Q 2  Q1) ( P 2  P1)
2
2
Note on the Sign of Price Elasticity
(E) of Demand
 The price elasticity of demand (E) is
always negative because quantity
demanded decreases when prices
increase.
 However, as we often use its absolute
value, the price elasticity of demand is
reported as a positive number (greater
than zero).
In Class Hands-on-Problem
Quantity Demanded
A
0.50
1
B
0.45
2
C
0.40
4
D
0.35
6
E
0.30
9
F
0.25
12
G
0.20
16
H
0.15
20
I
0.10
25
J
0.05
30
PRICE (per ounce)
Price
Compute Elasticity for
$0.55
A
A movement from
0.50
1. C to D
B
0.45
2. G to H
C
3. J to I
0.40
D
0.35
E
0.30
F
0.25
G
0.20
H
0.15
I
0.10
J
0.05
0 4 8 12 16 20 24 28 32
Quantity Demanded (Ounces per show)
Possible Values of Elasticity: |E|
 E can take any value between from 0 to
infinity
 Five Broad categories
 0<E<1; E=1; 1<E<Positive Infinity
 Two extreme Values (E=0 ; E=Positive
Infinity)
Elastic, Inelastic, Unitary Elastic
Demand
 If E is larger than 1, demand is elastic.
 Consumer response is large relative to the change
in price.
 Relatively Flat Demand Curve
 If E equals 1, demand is unitary elastic.
 If E is less than 1, demand is inelastic.
 Consumers aren’t very responsive to price
changes.
 Relatively Steeper Demand Curve
Elasticity Estimates
Elastic
Price
Elasticity
Estimate
Airline travel
2.4
(long run)
Restaurant
2.3
meals
Fresh fish
2.2
New cars
(short run)
1.2-1.5
Unitary
Private
education
Radios and
television
Shoes
Movies
Price
Elasticity
Estimate
1.1
Inelastic
Price
Elasticity
Estimate
Cigarettes
0.4
1.2
Coffee
0.3
0.9
Gasoline
(short run)
Electricity
(in homes)
0.2
0.9
0.1
Extremes of Elasticity
 Two extreme Values (E=0; E=Positive
Infinity)
 E=0: Perfectly inelastic.
 Quantity demanded will not change regardless of
the price change.
 A Vertical demand curve
 E=Infinity: Perfectly elastic
 Any price increase would cause demand to fall to
zero.
 A Horizontal demand curve.
Extremes of Elasticity
Perfectly elastic (E = )
Perfectly inelastic (E = 0)
p2
Price
Price
p2
p1
0
q1
Quantity
p1
0
q1
Quantity
Determinants of Elasticity
 The price elasticity of demand is
influenced by all of the determinants
of demand.
 Four factors are particularly worth
noting:




Necessities vs. Luxuries.
Availability of Substitutes.
Relative Price (to income).
Time.
Necessities vs. Luxuries
 Necessities are goods that are critical
to our day-to-day life.
 Demand for necessities is relatively
inelastic
• Luxuries are goods we would like to
have but are not likely to buy unless
our income jumps or the price declines
sharply.
 Demand for luxury goods is relatively
elastic.
Availability of Substitutes
 If a good has relatively many
substitutes, consumers are highly
sensitive to changes in the price of
the good.
 Thus the greater the availability of
substitutes, the higher is the price
elasticity of demand…relatively elastic
Relative Price (to income)
 Consumers are more sensitive to changes
in prices of goods that account for a
relatively larger share of their budget (at
higher price level) than those that account
for relatively smaller share of their budget
(lower price)
 The higher the price of a good relative to a
consumer’s income, the higher the elasticity of
demand.
 The price elasticity of demand declines as price
moves down the demand curve.
Time
 Consumers are better able to change
their buying habits over the long-run
(thus more sensitive to changes in
prices) than in the short-run (Less
sensitive).
 Thus in the long-run price elasticity of
demand is higher than the short-run
elasticity.
Elasticities and the Other
Determinants of Demand
 Price Elasticity of Demand
 Income Elasticity of Demand
 Cross Price Elasticity of Demand
Shifts vs. Movements
 Recall:
 When the price changes, the outcome is a
movement along the same demand curve.
 When any one of the underlying determinants of
demand (other than own price of the good)
changes, the entire demand curve shifts.
 Income and prices of other goods are
among such factors
Income Elasticity
 An increase (decrease) in consumer
income will cause a rightward
(leftward) shift in demand.
 I.e., consumers will purchase more at
any price than they did prior to the
increase in income.
Price of Popcorn (dollars per ounce)
Income Elasticity
Shift
0.25
F
N
D2 (after income rise)
D1 (before income rise)
0
12
16
Quantity of Popcorn (ounces per show)
Income Elasticity
 Income elasticity of demand is the
measure of the percentage change in
quantity demanded by the consumer
resulting from a percent change in
income of the consumer.
% change in
quantity demanded
Income elasticity
=
of demand
% change in income
Computing Income Elasticity
 As with price elasticity, income
elasticity is computed using average
values for the changes in quantity
and income.
change in quantity demanded
average quantity
Income elasticity =
change in income
average income
Normal vs. Inferior Goods
 A normal good has an income elasticity
of demand greater than zero.
 A normal good is a good for which
demand rises when income rises.
 An inferior good has an income
elasticity of demand less than zero.
 An inferior good is a good for which
demand decreases when income rises.
Cross-Price Elasticity
 A change in the price of one good
affects the demand for another.
 The decision to buy a good also depends
on the prices of substitutes and
complements of that good.
Cross-Price Elasticity
 Substitute goods are goods that substitute
for each other.
 When the price of good X rises, the demand for
good Y increases, ceteris paribus.
 Complementary goods are goods
frequently consumed in combination.
 When the price of good X rises, the demand for
complementary good Y falls, ceteris paribus.
Price of Popcorn
(cents per ounce)
Substitutes and Complements
0.25
R
F
D3
D1
D2
0
8
12
Quantity of Popcorn (ounces per show)
Calculating Cross-Price
Elasticity
 Cross price elasticity is the
percentage change in the quantity
demanded of X divided by percentage
change in price of Y.
% change in quantity
demanded of good X
Cross - price elasticity
=
of demand
% change in price
of good Y
Sign of Cross-Price Elasticity
 When the cross-price elasticity of
demand has a negative sign the two
goods are complementary goods.
 When the cross-price elasticity of
demand has a positive sign the two
goods are substitute goods.
Elasticity and Revenue
(Elasticity and Pricing Decision)
5.3. Elasticity and Pricing
Decision
 Strong relationship between price
elasticity and total revenue.
 Total revenue is The price of a product
multiplied by the quantity sold in a given
time period.
 Total revenue = Price X Quantity sold

TR= P X Q
5.3. Elasticity and Pricing
Decision
TR = P x Q
 Given the law of demand ( Price and
Quantity are inversely related), what
happens to the total revenue of the
seller when there is:
1. A Price Hike?
2. A Price Decline (Sales Discount)?
5.3. Elasticity and Pricing
Decision
 A price hike increases total revenue
of a seller only if demand is inelastic
(E < 1).
 if demand is elastic (E > 1), a hike in
price reduces total revenue of the seller.
 if demand is unitary elastic (E = 1), hike
in price does not change total revenue of
the seller
5.3. Elasticity and Pricing
Decision
 A decline in price (Sales Discount) on the
other hand increases total revenue of a seller
if the demand is elastic (E > 1).
 If the demand is inelastic (E<1) sales discount
doesn’t increase the total revenue of the
producer
 Implication?
Implication?
1. Most of the time, we get discounts for
luxury goods than necessities; and on
goods that account for relatively larger
share of our budget (those that have higher
prices)
2. The impact of a price change on total
revenue of the seller depends on the price
elasticity of demand.
3. Price elasticity changes along a demand
curve.
Price Elasticity and Total
Revenue
Price
$0.50
0.45
0.40
0.35
0.30
1
Quantity
Total
Demanded Revenue
1
$0.50
2
0.90
4
1.60
6
2.10
8
2.40
Price
$0.25
0.20
0.15
0.10
0.05
Quantity
Total
Demanded Revenue
12
$3.00
16
3.20
20
3.00
25
2.50
30
1.50
Price Elasticity and Total
Revenue
PRICE (per ounce)
At Lower prices E < 1
$0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0
At higher prices E > 1
B
C
2
4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
QUANTITY DEMANDED (ounces per show)
PRICE
The demand curve
$8
7
6
5
4
3
2
1
0
Elastic E > 1
Unit elastic E = 1
10
20
30
Inelastic E < 1
40 50 60 70 80 90 100 110
TOTAL REVENUE
Total revenue
$225
200
175
150
125
100
75
50
25
0
E=1
Elastic
E>1
10
20
30
40 50
60
Inelastic E
<1
70 80
90 100 110
How consumers Decide
to Allocate their Income
(Choosing Among Products)
5.4. Choosing Among Products
 Goal: Utility Maximization
 Consumers should choose the optimal
consumption combination.
 the mix of consumer purchases that
maximizes the utility attainable from
available income (budget).
5.4. Choosing Among Products
 The purchase of any one single good
also means giving up the opportunity
to buy more of other goods.

Recall Opportunity costs –
 The alternatively most desired goods or
services that are forgone in order to
obtain something else.
5.4. Choosing Among Products
 Economist assume that consumers
have Rational Behavior.
 Rational behavior requires one to
compare the anticipated utility of each
expenditure with its cost.
 Thus to maximize utility, the consumer
should choose that good which delivers
the most marginal utility per dollar.
Example…
Amount of Satisfaction (Utility) (in units of utility, or utils)
From Cokes(X)
From Video Games(Y)
Quantity
Consumed
Total
Maginal
Total
Marginal
0
0
0
0
0
1
15
15
10
10
2
23
8
19
9
3
25
2
26
7
4
25
0
31
5
5
22
-3
34
3
6
12
-10
35
1
Utility Maximizing Rule
 If a person could get more utility per
dollar by buying good X, then she
should continue to buy good X.
If MUX > MUY  buy more X
PX
PY
If MUX < MUY  buy more Y
PX
PY
Utility Maximizing Rule
 If a person could get more utility per
dollar by buying good Y, then she
should
continue
to
buy
good
Y.
MU
X
MU
Y
If
>
 buy more X
PX
PY
If MUX < MUY  buy more Y
PX
PY
Utility Maximizing Rule
 Continue this process until the ratios
are equal – only then will utility be
maximized.
Utility maximizing rule: MUX = MUY
PX
PY
Example…
The consumer has $10; Px=$1 and Py=$2. To get Max Utility
How much of each good should the consumer purchase?
Amount of Satisfaction (Utility) (in units of utility, or utils)
From Cokes(X)
From Video Games(Y)
Quantity
Consumed
Total
Maginal
Total
Marginal
0
0
0
0
0
1
15
15
10
10
2
23
8
19
9
3
25
2
26
7
4
25
0
31
5
5
22
-3
34
3
6
12
-10
35
1
The Outcome: Optimal
 Economic theory predicts that the
final choices of consumers -- the
equilibrium outcome -- will be
optimal.
 There is no better combination that
gives more utility for the money
(budget), given the prices
The Outcome: Optimal
Why advertising then?
The Outcome: Optimal
 Some advertising is intended to
provide information about new or
existing products.
 A great deal more of advertising is
designed to exploit our senses and
lack of knowledge.
 Advertising can’t be blamed for our
foolish consumption
The Outcome: Optimal
 A successful advertising campaign is
one that shifts the demand curve to
the right.
Price (dollars per unit)
Impact of Advertising on the
Demand Curve
Demand curve
after advertising
P
Demand curve
before advertising
0
Q1
Q2
Quantity Demanded (units per time period)