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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. Copyright © Houghton Mifflin Company. All rights reserved. 5| 2 Utility and Consumer Preferences Figure 5.2 (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 5| 3 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). Copyright © Houghton Mifflin Company. All rights reserved. 5| 4 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). Copyright © Houghton Mifflin Company. All rights reserved. 5| 5 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. Copyright © Houghton Mifflin Company. All rights reserved. 5| 6 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. Copyright © Houghton Mifflin Company. All rights reserved. 5| 7 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). Copyright © Houghton Mifflin Company. All rights reserved. 5| 8 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. Copyright © Houghton Mifflin Company. All rights reserved. 5| 9 The Budget Constraint (cont’d) Figure 5.3 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 10 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 11 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 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 12 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 Copyright © Houghton Mifflin Company. All rights reserved. 30 40 50 Qcoke 5 | 13 The Budget Constraint: Another Example Qhotdogs Qhotdogs Qcoke Effect of a decrease in the price of hotdogs. Copyright © Houghton Mifflin Company. All rights reserved. Qcoke Effect of a decrease in the price of coke. 5 | 14 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 15 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 16 The Budget Constraint and Utility Maximization (cont’d) Figure 5.4 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 17 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 18 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 19 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 20 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). Copyright © Houghton Mifflin Company. All rights reserved. 5 | 21 The Effect of a Change in Price (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 5 | 22 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 23 The Effect of a Change in Income (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 5 | 24 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 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 25 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 26 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 27 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 28 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 29 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 30 Willingness to Pay and the Demand Curve (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 5 | 31 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 32 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 33 Willingness to Pay and the Demand Curve (cont’d) Figure 5.6 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 34 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 35 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). Copyright © Houghton Mifflin Company. All rights reserved. 5 | 36 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 37 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?” Copyright © Houghton Mifflin Company. All rights reserved. 5 | 38 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 39 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 40 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 41 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 42 The Market Demand Curve (cont’d) Figure 5.8 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 43 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 44 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 45 Consumer Surplus (cont’d) • Figure 5.9 and Figure 5.10 graphically illustrate the consumer surplus for an individual and for the market. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 46 Consumer Surplus (cont’d) Figure 5.9 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 47 Consumer Surplus (cont’d ) Figure 5.10 Copyright © Houghton Mifflin Company. All rights reserved. 5 | 48 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. Copyright © Houghton Mifflin Company. All rights reserved. 5 | 49 Key Terms • • • • • • • Utility Budget constraint Utility maximization Income and substitution effect Marginal benefit Individual and market demand curve Consumer surplus Copyright © Houghton Mifflin Company. All rights reserved. 5 | 50