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Demand Analysis
Some Questions
• What is behind a consumer’s demand
curve?
• How do consumers choose from among
various consumer “goods”?
• What determines the value of a
consumer good?
What is Consumer Theory?
• Study of how people use their limited means to
make purposeful choices.
• Assumes that consumers understand their choices
(possibilities) and the prices (opportunity costs)
associated with each choice.
• Assumes that consumers consider the alternatives
and choose the one they like best.
Consumer Theory - Why?
• Two important reasons:
– to understand the foundations of market
demand (bake the demand curve from
scratch)
– to address several interesting consumer
theory issues that are best understood
using this model rather than the aggregate
demand model
Two Components of
Consumer Demand
• Opportunities:
– What can the consumer afford?
– What are the consumption possibilities?
– Summarized by the budget constraint
• Preferences:
– What does the consumer like?
– How much does a consumer like a good?
– Summarized by the utility function
Utility
• The value a consumer places on a unit of a good or
service depends on the pleasure or satisfaction he or she
expects to derive form having or consuming it at the
point of making a consumption (consumer) choice.
• In economics the satisfaction or pleasure consumers
derive from the consumption of consumer goods is called
“utility”.
• Consumers, however, cannot have every thing they wish
to have. Consumers’ choices are constrained by their
incomes.
• Within the limits of their incomes, consumers make their
consumption choices by evaluating and comparing
consumer goods with regard to their “utilities.”
Our basic assumptions about a
“rational” consumer:
• Consumers are utility maximizers
• Consumers prefer more of a good (thing) to less of it.
• Facing choices X and Y, a consumer would either prefer
X to Y or Y to X, or would be indifferent between them.
• Transitivity: If a consumer prefers X to Y and Y to Z,
we conclude he/she prefers X to Z
• Diminishing marginal utility: As more and more of good
is consumed by a consumer, ceteris paribus, beyond a
certain point the utility of each additional unit starts to
fall.
How to Measure Utility
Measuring utility in “utils” (Cardinal):
• Jack derives 10 utils from having one slice of pizza but only 5 utils from
having a burger.
• In many introductory microeconomics textbooks this approach to
measuring utility is still considered effective for teaching purposes.
Measuring utility by comparison (Ordinal):
• Jill prefers a burger to a slice of pizza and a slice of pizza to a hotdog.
Often consumers are able to be more precise in expressing their preferences.
For example, we could say:
• Jill is willing to trade a burger for four hotdogs but she will give up only
two hotdogs for a slice of pizza.
• We can infer that to Jill, a burger has twice as much utility as a slice of
pizza, and a slice of pizza has twice as much utility as a hotdog.
Utility and Money
• Because we use money (rather than hotdogs!) in just about
all of our trade transactions, we might as well use it as our
comparative measure of utility.
(Note: This way of measuring utility is not much different
from measuring utility in utils)
• Jill could say: I am willing to pay $4 for a burger, $2 for a
slice of pizza and $1 for a hotdog.
Note: Even though Jill obviously values a burger more (four
times as much) than a hot dog, she may still choose to buy a
hotdog, even if she has enough money to buy a burger, or a
slice of pizza, for that matter. (We will see why and how
shortly.)
Total Utility versus Marginal Utility
• Marginal utility is the utility a consumer
derives from the last unit of a consumer good
she or he consumes (during a given
consumption period), ceteris paribus.
• Total utility is the total utility a consumer
derives from the consumption of all of the
units of a good or a combination of goods
over a given consumption period, ceteris
paribus.
Total utility = Sum of marginal utilities
The Law of Diminishing Marginal
Utility
• Over a given consumption period, the more of a good a
consumer has, or has consumed, the less marginal
utility an additional unit contributes to his or her overall
satisfaction (total utility).
• Alternatively, we could say: over a given consumption
period, as more and more of a good is consumed by a
consumer, beyond a certain point, the marginal utility
of additional units begins to fall.
Total and Marginal Utility for Ice
Cream
Q
0
1
2
3
4
5
6
7
8
9
10
($) TU
0
40
85
120
140
150
157
160
160
155
145
($) MU
40
45
35
20
10
7
3
0
-5
-10
145
Total Utility
200
150
100
50
0
1
2
3
4
5
6
7
8
9
7
8
9
10 11
($) M U
50
40
30
20
10
0
1
-10
-20
2
3
4
5
6
1
11
Q
0
1
2
3
4
5
6
7
8
9
10
($) TU
0
40
85
120
140
150
157
160
160
155
145
($) MU
40
45
35
20
10
7
3
0
-5
-10
145
How much ice cream does Jill buy in a month?
Some facts of life:
• Limited income
• Opportunity cost of making a choice:
Buying ice cream leaves Jill less money to
buy other things: each dollar spent on ice
cream could be spent on hamburger.
• In fact, consumers compare the (expected)
utility derived from one additional dollar
spent on one good to the utility derived from
one additional dollar spent on another good.
What is a Budget Constraint?
• A budget constraint shows the consumer’s
purchase opportunities as every combination
of two goods that can be bought at given
prices using a given amount of income.
• The budget constraint measures the
combinations of purchases that a person can
afford to make with a given amount of
monetary income.
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
(Unattainable)
6
4
2
(Attainable)
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
(Unattainable)
6
4
2
(Attainable)
0
2
4
6
8
Quantity of B
10
12
THE BUDGET LINE:
What is Attainable
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
(Unattainable)
6
4
2
(Attainable)
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
j
Units
of A
Units
of B
12
2
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
j
k
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
k
6
4
Units
of A
Units
of B
2
12
6
2
4
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
j
k
l
Units
of A
Units
of B
12
6
4
2
4
6
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
k
6
l
4
2
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
k
6
l
4
m
2
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
k
6
l
4
m
I
2
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
j
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
k
6
The slope
represents
the marginal
rate of substitution, (MRS)
l
4
m
2
I2
I1
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
2
I1
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
I4
I3
2
I2
I1
0
2
4
6
8
Quantity of B
10
12
INDIFFERENCE CURVES
What is Preferred
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
12
An
Indifference
Map
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
8
6
4
I4
I3
2
I2
I1
0
2
4
6
8
Quantity of B
10
12
EQUILIBRIUM AT TANGENCY
8
6
4
2
0
0 $12
3 12
6 12
9 12
12 12
An Indifference
Schedule
Combination
Units
of A
j
k
l
m
12
6
4
3
Units
of B
2
4
6
8
12
10
Quantity of A
Units of Units of
Total
A Price B Price
$1.50
$1.00 Expenditures
(Unattainable)
8
6
4
2
I4
I3
I2
(Attainable)
I1
0
2
4
6
8
Quantity of B
10
12
EQUILIBRIUM AT TANGENCY
(Unattainable)
Quantity of A
Equilibrium 12
occurs when
the consumer 10
selects the
8
combination
which reaches 6
the highest
4
attainable
indifference
2
curve.
I4
I3
I2
(Attainable)
I1
0
2
4
6
8
Quantity of B
10
12
EQUILIBRIUM AT TANGENCY
What happens if the price of B
increases to $1.50?
The budget line
rotates reflecting
the reduction in
the quantity of B
units which is
attainable.
12
$1.00
6
Quantity of A
PriceB QuantityB 10
8
6
4
2
I3
0
2
4
6
8
Quantity of B
10
12
EQUILIBRIUM AT TANGENCY
What happens if the price of B
increases to $1.50?
The budget line
rotates reflecting
the reduction in
the quantity of B
units which is
attainable.
12
$1.00
1.50
6
3
Quantity of A
PriceB QuantityB 10
8
6
4
2
By recording the
various quantities 0
demanded at the
various prices yields
the Demand schedule
I3
I2
2
4
6
8
Quantity of B
10
12
EQUILIBRIUM AT TANGENCY
What happens if the price of B
increases to $1.50?
The budget line
rotates reflecting
the reduction in
the quantity of B
units which is
attainable.
12
$1.00
1.50
6
3
Quantity of A
PriceB QuantityB 10
8
6
4
2
By recording the
various quantities 0
demanded at the
various prices yields
the Demand schedule
I3
I2
2
4
6
8
Quantity of B
10
12
DERIVING THE DEMAND CURVE
What happens if the price of B
increases to $1.50?
Price of B
PriceB QuantityB
$1.00
1.50
6
3
$1.50
Plotting the
Points yields the
Demand Curve
for Product B
1.00
By recording the
various quantities 0
demanded at the
2
various prices yields
the demand schedule.
DB
4
6
8
Quantity of B
10
12