DEMAND & CONSUMER BEHAVIOUR

AIMS & OBJECTIVES

After studying this lesson, you will be able to understand: Concept of Utility & utility theory Law of diminishing marginal utility & Law of equi-marginal utility Consumers equilibrium Downward slope of demand curve Income effect & substitution effect Market demand curve The paradox of value Consumer Surplus Indifference Curve, budget constraint & consumers equilibrium Price Consumption Curve Income Consumption Curve
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SLOPE OF DEMAND CURVE: EXPLAINED WITH

UTILITY ANALYSIS

Recall: A demand curve, each point on which shows the quantity purchased of a good at a given prices, is downward sloping as quantity demanded of a good is inversely related to its price Now Qs. is: Why does quantity demanded move in the opposite direction to that of price? Answer to this lies in utility analysis.

UTILITY ANALYSIS

Utility refers to the usefulness of a good Two important concepts of utility are: Total Utility (TU) and Marginal Utility (MU) TU sum total of utility derived from all units of a good consumed MU additional utility derived from each additional unit of a good consumed. Thus,

MU = d(TU)/dq = MUn+1 Mun

Where q denotes units consumed and n and (n+1) denotes two successive units consumed

RELATION BETWEEN TU & MU

MU measures the rate of change in TU. It gives the change in utility with an additional unit of the good consumed TU rises at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU diminishes, becomes zero and becomes negative thereafter TU may sometimes rise initially at an increasing rate, then at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU rises at first, then diminishes, then becomes zero and becomes negative thereafter

Quantity of a good consumed 1 2 3 4 5 6

Total Utility

Marginal Utility 4 3 2 1 0 -2

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LAW OF DIMINISHING MARGINAL UTILITY

Marginal utility usually diminishes throughout or may rise briefly at first and then diminish throughout. This tendency leads to a very important law the Law of Diminishing Marginal Utility (LDMU) The Law states - As a consumer consumes more and more units of a particular good, the Marginal utility derived from each additional unit diminishes

CONSUMERS EQUILIBRIUM

Equilibrium for any economic agent refers to a state of balance in terms of his receipts & what he has to forego

For a consumer the balance is ensured when the utility he receives from consumption of a good is equal to what he foregoes by the way of price he pays for the good

SLOPE OF DEMAND CURVE EXPLAINED BY LDMU

Let a consumer buying/consuming good X be initially in equilibrium i.e. MUx = Px i.e. what he is receiving as utility is exactly balanced by what he is foregoing as price. He is making the best use of his resources to reach the maximum satisfaction/value Now let Px MUx > Px equilibrium disturbed. The consumer is now getting more value than he is foregoing. So he would want to get more and increase his consumption Qx . As Qx, MUx (LDMU works) and the system starts moving back to MUx = Px . The consumer reaches equilibrium once again. In the process Qx . Thus as Px Qx which explains the inverse prices quantity relationship for a product.

LAW OF EQUI-MARGINAL UTILITY (LEMU)

In the real world a consumer takes his consumption decision not with respect to one product but with respect to a number of products he purcahes/consumes. Thus, he does not quite reach his equilibrium when MUx = Px He reaches his equilibrium when marginal utility of his expenditure in all directions of his purchases are equalized i.e. if he is buying two goods X & Y at prices Px & Py then he is in equilibrium when MUx/Px = MUy/Py = MUm where Mum denotes marginal utility from total money he has. This is referred to as consumers equilibrium as per law of equimarginal utility

SLOPE OF DEMAND CURVE EXPLAINED BY LEMU

Let a consumer buying/consuming two goods X & Y be initially in equilibrium i.e. MUx/Px = MUy/Py i.e. the marginal utility of expenditure on X is equal to the marginal utility of expenditure on Y. Hence he consumes both and maximizes his utility. Now let Px MUx/Px > MUy/Py equilibrium disturbed. The consumers MU of expenditure on X is greater than MU of expenditure on Y and hence he wants buy more of X with his scarce money Qx . As Qx, MUx (LDMU works) and the system starts moving back to MUx/Px = MUy/Py . The consumer reaches equilibrium once again. In the process Qx . Thus as Px Qx which explains the inverse prices quantity relationship for a product

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SLOPE OF A DEMAND CURVE REVISITED

The inverse price-quantity relationship and hence the downward slope of a demand curve may also be explained with the help of the following two concepts: Income effect Substitution effect

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INCOME EFFECT

When the price of a commodity falls less has to be spent on the purchase of the same quantity of the commodity. This leads to an increase in purchasing power of the money with the buyer. This is referred to an increase in real income of the consumer. The increase in real income leads to an increase in purchase of the commodity whose price has fallen. This is referred to as income effect of a price change.

Px Real income Qx

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INCOME EFFECT NEGATIVE OR POSITIVE?

Px Real income Qx income effect is positive X is a normal good Px Real income Qx income effect is negative X is an inferior good

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SUBSTITUTION EFFECT

When price of a commodity falls, its becomes cheaper relative to other commodities. This leads to substitution of other commodities( which are now relatively more expensive) by this commodity. Thus the demand for the cheaper good rises. This is called the substitution effect.

Px it is relatively cheaper and hence attractive Qx

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SUBSTITUTION EFFECT NEGATIVE OR POSITIVE?

Substitution effect is always positive.

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INFERIOR GOOD VS GIFFEN GOOD

A good with negative income effect is referred to as inferior good A good whose negative income effect dominates the positive substitution effect is a Giffen good. Thus, all Giffen goods are inferior goods but all inferior goods are not Giffen goods

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MARKET DEMAND CURVE

The market demand curve is the sum of individual demands at each price Graphically, a market demand curve is the horizontal summation of individual demand curves

THE PARADOX OF VALUE

Why does water so essential and hence valuable for life command either a small or no price? While diamond which is only an item of conspicuous consumption command such a high price? The answer lies in the fact that while diamond is scarce, water is abundant. Besides, as price for water is fixed based on additional units of consumption, the additional units of utility derived from consumption of additional units of water gradually diminishes.

CONSUMERS SURPLUS

This refers to the difference between what a consumer is willing to pay and what he actually pays

Consumer surplus

P
D
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FURTHER BEHIND THE DEMAND CURVE

Consumers equilibrium can also be explained using the two concepts of: Indifference curve Budget Line

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INDIFFERENCE CURVES

An indifference shows various combinations of two goods that fetches the same level of utility/satisfaction to the consumer Basic Characteristics of Indifference Curves Higher indifference curves represent higher levels of utility Indifference curves do not intersect. Indifference curves slope downward. Indifference curves are concave to origin.

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SLOPE OF AN INDIFFERENCE CURVE & MRSXY

Slope of an Indifference Curve = - dY/dX = the Marginal rate of technical substitution between X & Y (MRSxy) = -MUX/MUY The Marginal rate of technical substitution between X & Y (MRSxy) represents the rate at which X gets substituted for Y as a consumer moves down an indifference curve The MRSxy diminishes as one moves down an indifference curve. This is the Law of Diminishing Marginal Rate of substitution. This explains the concave to the origin (or convex from the origin) property of an indifference curve

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BUDGET CONSTRAINTS

Budget constraint shows the various combinations of two goods that a consumer can have for a given money outlay

If a consumer is buying only two goods X and Y in quantities x & y respectively and at prices Px and Py respectively with his entire income M then
M = xPx + yPy This represents the consumers budget constraint or budget line

Basic Characteristics of Budget Constraints Shows affordable combinations of X and Y. Slope of PX/PY reflects relative prices.
Effect of increase in relative prices Slope of Budget line changes. It shifts outward/inward with one of its points either on Y axis(when Px changes) or on X axis (when Py changes) remaining fixed Effects of Changing Income with prices constant Income increase causes parallel outward shift. Income decrease causes parallel inward shift.
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OPTIMAL CONSUMPTION/CONSUMERS
EQUILIBRIUM

A consumer does his optimal consumption at the point where his utility is maximized subject to this budget constraint i.e. he reaches the highest possible indifference curve given the budget constraint Mathematically, this Utility Maximization happens when the budget line becomes tangent to the highest possible indifference curve for the consumer. At this point slope of budget line becomes equal to slope of indifference curve (IC) i.e. -PX/PY = - MRSxy = - MUX/MUY. i.e. MUX/PX = MUY/PY.

Condition for Consumers equilibrium. This is same as obtained from Law of equi-marginal utility
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Each of A, B, C represents consumers Equilibrium for different budget constraint faced by the consumer.

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PRICE CONSUMPTION CURVE, INCOME CONSUMPTION CURVE, ENGLE CURVE

Price-consumption Curve Shows how consumption is affected by price changes (movement along demand curve). Income-consumption Curve Shows how consumption is affected by income changes (shifts from one demand curve to another).

Engle Curves Plot between income and quantity consumed. Consumption of normal goods rises with income. Consumption of inferior goods falls with income (rare).

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