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Chapter Five
The Demand
Curve and the
Behavior of
Consumers
Utility and Consumer Preferences
• Utility – A numerical indicator of a person’s
preferences in which higher levels of utility
indicate a greater preference.
• The following figure illustrates an example
of utility that an individual gets from
consuming two goods, grapes and
bananas.
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Utility and Consumer Preferences
Figure 5.2 (cont’d)
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Utility and Consumer Preferences (cont’d)
• We will use utility to identify combinations
of goods that are more preferred to other
combinations of goods. To do this, we
assign a higher utility value to bundles of
goods that are more preferred. From the
previous figure, the sample consumer
prefers four pounds of grapes and one
pound of bananas (utility value = 25) to
one pound of grade and two pounds of
bananas (utility = 23).
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Utility and Consumer Preferences (cont’d)
•
With combinations of goods that give
exactly the same level of utility, the
consumer is indifferent between those
two combinations. For example, the
sample consumer is indifferent between
two pounds of grapes + two pounds of
bananas and one pound grapes + three
pounds bananas, since both
combinations yield the same utility level
(utility = 27).
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Utility and Consumer Preferences (cont’d)
• One thing to remember with utility is that
utility is ordinal. The value of utility is used
solely for ranking combinations of goods
and services. We cannot make the
conclusion that a bundle with a
corresponding utility level of 20 makes a
consumer twice as happy as with a bundle
with a utility level of 10.
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The Budget Constraint
• Budget constraint – An income limitation
on a person’s expenditures on goods and
services. It tells us that expenditures on
all goods and services can only be equal
to or less than a specified amount, or a
budget.
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The Budget Constraint (cont’d)
• Suppose a pound of grapes costs $2 and
a pound of bananas costs $1. If you have
a spending limit of $8, then the
combination of four pounds of grapes and
one pound of bananas is beyond your
spending limit (total cost = $9). Similarly,
the combination of four pounds of bananas
and one pound of grapes is under your
spending limit (total cost = $6).
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The Budget Constraint (cont’d)
• The following figure shows the total cost of
purchasing the different combinations of
grapes and bananas. The graph on the
left calculates expenditures with bananas
and grapes costing $1 per pound. The
graph on the right calculates expenditures
with bananas costing $1 per pound and
grapes at $2 per pound.
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The Budget Constraint (cont’d)
Figure 5.3
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The Budget Constraint (cont’d)
• From the previous figure , combinations that cost
more than $8 are shaded in red.
• Comparing the two graphs in the figure, notice
that an increase in the price of grapes increases
the number of combinations that are shaded in
red, resulting into fewer combinations of
bananas and grapes that are affordable to the
consumer at a spending limit of $8.
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The Budget Constraint:
Another Example
Suppose you consume only two goods, hotdogs and coke, and your
budget for both goods is $75. A hotdog costs $3 while a bottle of cocacola costs $1.50. The table below shows a list of possible combinations
of hotdogs and coke that exhausts your budget.
A
B
C
D
E
F
Hotdogs ($3 each)
Coke ($1.50 each)
Quantity
Expenditures Quantity
Expenditures
0
0
50
75
5
15
40
60
10
30
30
45
15
45
20
30
20
60
10
15
25
75
0
0
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The Budget Constraint:
Another Example
Qhotdogs
25
F
E
20
D
15
Slope of budget line = the relative
price of a hotdog = opportunity
cost of one more hotdog.
C
10
B
5
A
10
20
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30
40
50
Qcoke
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The Budget Constraint:
Another Example
Qhotdogs
Qhotdogs
Qcoke
Effect of a decrease in the
price of hotdogs.
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Qcoke
Effect of a decrease in the
price of coke.
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The Budget Constraint and Utility
Maximization
• Utility maximization – An assumption that
people try to achieve the highest level of
utility given their budget constraint.
• To understand utility maximization using
our example of grapes and bananas, we
need to combine the utility information with
the cost information from the previous two
figures.
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The Budget Constraint and Utility
Maximization (cont’d)
• Figure 5.4 shows two of the same graph
as Figure 5.2, but with the red shading
consistent with Figure 5.3. The red areas
still identify the combinations of grapes
and bananas that are beyond the
spending limit of $8, given the different
price prices of grapes and bananas.
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The Budget Constraint and Utility
Maximization (cont’d)
Figure 5.4
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The Budget Constraint and Utility
Maximization (cont’d)
• From Figure 5.4, the square with the bold
number identifies the affordable
combination of grapes and bananas that
gives the consumer the highest level of
utility, at a given price of grapes.
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The Budget Constraint and Utility
Maximization (cont’d)
• The graph on the left of Figure 5.4, the
utility maximizing combination is four
pounds of grapes and four pounds of
bananas, given that the price of grapes
and bananas are $1 per pound. On the
right side graph of Figure 5.4, the utility
maximizing combination is 2 pounds of
grapes and four pounds of bananas,
because the price of grapes increased to
$2 per pound.
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The Effect of a Change in Price
• From Figure 5.4, we can see that if the
consumer were utility maximizing, then an
increase in the price of grapes from $1 to
$2 per pound (holding the price of bananas
to $1 and the spending limit to $8) will
induce the consumer to decrease the
quantity demanded of grapes from 4 to 2.
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The Effect of a Change in Price (cont’d)
• If we illustrate this change on a graph with the
price of grapes on the Y-axis and quantity
demanded of grapes on the X axis, then what
we have derived is exactly the price and quantity
relationship we now know as the demand curve.
• The increase in the price resulted in a
movement along the demand curve from
coordinates (4,4) to the coordinates (4,2).
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The Effect of a
Change in Price
(cont’d)
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The Effect of a Change in Income
• A change in income (and hence, the budget or
spending limit) will shift the demand curve to the
left. To illustrate, suppose the spending limit
decreases from $8 to $5. If the prices of
bananas and grapes remain the same, then a
closer look at Figure 5.2 and Figure 5.3 will
show that the utility maximizing quantity of
grapes demanded will drop from 4 to 2 if the
price of grapes were $1, and 2 to 1 if the price of
grapes were $2.
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The Effect of a
Change in Income
(cont’d)
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The Income and Substitution Effect
•
The reason why the increase in the price
of grapes (or any good) results in a
decrease in the quantity demanded of
that good can be broken down into two
effects:
1) The Income Effect of a Change in Price
2) The Substitution Effect of a Change in Price
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The Income and Substitution Effect
(cont’d)
• The income effect – The amount by which the
quantity demanded falls because of a decline in
real income from a price change.
• An increase in the price of one good (holding the
price of the other good and the budget constant)
reduces the spending power of the original
budget (you cannot afford as much), making it
seem like the income has dropped.
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The Income and Substitution Effect
(cont’d)
• Similarly, a decrease in the price of one good
(holding the price of the other good and the
budget constant) increases the spending power
of the original income (you can now buy the
same bundle and still have extra), making it
seem like the income has increased.
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The Income and Substitution Effect
(cont’d)
• The substitution effect – the amount by which
the quantity demanded falls when the price
rises, exclusive of the income effect.
• An increase in the price of one good (holding the
price of the other good and the budget
constant), makes that good relatively more
expensive, so we tend to switch our spending
away from that good and buy more of the good
whose price remained the same.
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The Income and Substitution Effect
(cont’d)
• A decrease in the price of one good (holding the
price of the other good and the budget
constant), makes that good relatively less
expensive, so we tend to switch our spending
toward that good and away from the good
whose price remained the same.
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Willingness to Pay and the
Demand Curve
• Marginal Benefit – the increase in the
benefit from, or the willingness to pay for,
one more unit of a good.
• Table 5.1 shows a hypothetical example of
how we calculate Marginal Benefit.
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Willingness to Pay
and the
Demand Curve (cont’d)
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Willingness to Pay and the
Demand Curve (cont’d)
• From Table 5.1, marginal benefit of consuming
the third unit of X can be calculated by taking the
difference of the willingness to pay two units of X
and three units of X. In this case, the marginal
benefit of the third unit of X is $3.00.
• Observe that the marginal benefit of consuming
one more unit of X in Table 5.1 diminishes as
more of X is consumed.
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Willingness to Pay and the
Demand Curve (cont’d)
• The demand curve can also be derived
from the information on the marginal
willingness to pay for a good.
• To proceed, we plot Table 5.1 into a graph
with quantity of the good on the X-axis and
dollars on the Y-axis. This is illustrated in
Figure 5.6.
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Willingness to Pay and the
Demand Curve (cont’d)
Figure 5.6
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Willingness to Pay and the
Demand Curve (cont’d)
• Individual demand curve: A curve showing
the relationship between the quantity
demanded of a good by an individual and
the price of the good.
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Willingness to Pay and the
Demand Curve (cont’d)
• To derive the demand curve, one must simply
compare the willingness to pay with the price of
a good. For example, in Figure 5.6, if the price
of a good is $2, then the consumer will want to
buy the first and the second unit because the
marginal benefit is greater than the price. The
consumer will not want to buy the third unit at
that price because the marginal benefit ($1.50)
is less than the price of the good ($2.00).
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The Price Equals Marginal Benefit Rule
• If consumers can adjust consumption of a
good in small increments – such as
fractions of a pound – then the consumer
will buy an amount for which the price
equals the marginal benefit. This rule
helps explain a famous paradox in
economics called “The Diamond – Water
Paradox.”
• Paradox – A seemingly contradictory statement
that may nonetheless be true.
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The Price Equals Marginal
Benefit Rule (cont’d)
The Diamond - Water Paradox:
• “Why are diamonds expensive and water
cheap even though diamonds are less
‘useful’ to the world’s population than
water?”
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The Price Equals Marginal
Benefit Rule (cont’d)
The Diamond – Water Paradox: Explanation
• Using our Price = Marginal Benefit Rule,
we can argue that the price of diamonds
are high because the marginal benefit is
high. The price of water is low because
the marginal benefit of an additional glass
of water is low.
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The Price Equals Marginal
Benefit Rule (cont’d)
The Diamond – Water Paradox: Explanation
• The total benefit we get from water may be
high, but because it is very abundant (about
70 percent of the earth’s surface is covered with water),
the marginal benefit we get from one
additional unit of water is low, hence, the
price of water is low.
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The Price Equals Marginal
Benefit Rule (cont’d)
The Diamond – Water Paradox: Explanation
• The total benefit we get from diamonds
may be less than the total benefit we get
from water. However, because diamonds
are more scarce than water, the marginal
benefit from diamonds are higher, hence a
higher price for diamonds.
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The Market Demand Curve
• Market demand curve – The horizontal
summation of all individual demand curves
for a good; also simply called as the
demand curve.
• Figure 5.8 shows an example of the
horizontal summation of individual demand
curves to derive the market demand curve.
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The Market Demand Curve (cont’d)
Figure 5.8
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Different Types of Individuals
• Even if the demand curves of individuals
are not smooth, the market demand curve
will be smooth because people have
different tastes and preferences.
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Consumer Surplus
• Consumer surplus – The difference between
what a person is willing to pay for an additional
unit of a good (or the marginal benefit of a good)
and the market price of the good.
• For the market as a whole, the consumer
surplus is the sum of the consumer surpluses of
all individuals in the market. This can be found
by taking the area below the demand curve and
above the price.
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Consumer Surplus (cont’d)
• Figure 5.9 and Figure 5.10 graphically
illustrate the consumer surplus for an
individual and for the market.
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Consumer Surplus (cont’d)
Figure 5.9
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Consumer Surplus (cont’d )
Figure 5.10
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Consumer Surplus (cont’d)
Notes:
1) An individual who is willing to pay less than the
market price (and hence, did not purchase the
good) will have a consumer surplus equal to
zero.
2) A higher price will result in a smaller consumer
surplus for the market and the individual.
3) A lower price will result in a larger consumer
surplus for the market and the individual.
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Key Terms
•
•
•
•
•
•
•
Utility
Budget constraint
Utility maximization
Income and substitution effect
Marginal benefit
Individual and market demand curve
Consumer surplus
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