Consumer Demand Theory

3 Basic Assumptions
Each consumer has complete information on all matters pertaining to consumer decisions
The consumer knows the range of goods available in the market and the capacity of the good to satisfy human wants

The exact price of each good is known. The consumer knows his income during the planning period

3 Basic Assumptions
Given the 3 assumptions, each consumer tries to maximize utility/satisfaction/happiness given a limited income. Utility the satisfaction a consumer derives from whatever good/service he/she consumes. This is the basis of choice.

Two Approaches
Marginal Utility Approach Indifference Curve Approach

Marginal Utility Approach

Assumption: Utility is measurable and quantifiable Util a measure of pleasure or satisfaction Total Utility (TU) 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

Marginal Utility Approach

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.
MU TU Q

- the slope of total utility curve

Total Utility and Marginal Utility

No of cones 0 1 2 3 4 5
Hall & Leiberman; Economics: Principles And Applications, 2004

Total utility 0 utils 30 utils 50 utils 60 utils 65 utils 68 utils 69 utils

Marginal Utility

30 utils 20 utils 10 utils 5 utils 3 utils 1 utils

7

Total And Marginal Utility

Utils 70 60 50 40 30 20 10 1 2 3 4 Total Utility 1. The change in total utility from one more ice cream cone . . .

5 6 Ice Cream Cones per Week 3. Marginal utility falls as more cones are consumed. Marginal Utility

Utils

30 20 10

2. is called the marginal utility of an additional cone.

1
Hall & Leiberman; Economics: Principles And Applications, 2004

5 6 Ice Cream Cones per Week

8

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 10 11

($) M U

50 40 30 20 10 0 1 -10 -20 2 3 4 5 6 7 8 9 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

Total Utility and Marginal Utility

Saturation point a point where increase in consumption of unit of a good, total utility did not increase.
In the schedule it is between 7 and 8

The Law of Diminishing Marginal Utility

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.

CONSUMER SURPLUS
= the gap between the total utility of a good and its total market value The surplus arises because we receive more than we pay for, it is rooted in the law of diminishing marginal utility we pay for each unit what the last unit is worth but by the law of diminishing marginal utility the earlier units are worth more to us than the last thus, we enjoy a surplus of utility on each of these earlier units

Consumer Surplus
The difference between what a consumer is willing to pay for an addition unit of a good and the market price that he/she actually pays is referred to as consumer surplus. The area between the demand curve and the price (line) measures the total consumer surplus.

Consumer Surplus
P

Price

D Qx 0

Diamond/Water Paradox
The things with the greatest value use frequently have little or no value in exchange, and The things with the greatest value in exchange frequently have little or no value in use.

Diamond/Water Paradox
Why is water which is essential to life so cheap while diamonds which are not essential to life so expensive? Water has a great use value but low exchange value because supply is abundant. Even at a price of zero we do not consume an infinite amount of water. We consume up to the point where MU drops to zero.

Diamond/Water Paradox
Diamond low use value but high exchange value. low supply MU tends to be very high willing to pay a high price

Price of the good is determined by the MU of the last unit of a good not by the TU.

Indifference Curve Analysis

1881 Francis Y. Edgeworth, British Economist, introduced the IC technique 1906 IC technique was adopted by an Italian Economist, Vilfredo Pareto 1930s 2 British Economists: John R. Hicks and Roy George Douglas Allen popularized the IC technique

Assumptions on the nature of consumer preferences

Preferences are complete.
The consumer is able to set up a preference ranking of the combinations available. X > Y X is preferred over Y Y>X Y is preferred over X X Y indifferent between X and Y

Assumptions on the nature of consumer preferences

Preferences are transitive.
The consumer makes choices that are consistent with each other. A > B, B>C therefore, A>C

More is better.
The consumer prefers more of any goods or services to less of it because more goods or services give her a higher level of satisfaction

Preferences: What the Consumer Wants

Indifference curve: Quantity shows consumption of Mangos bundles that give the consumer the same level of satisfaction A consumption bundle is a particular combination of the goods, e.g., 40 fish & 300 mangos. A, B, and all other bundles on I1 makes a person equally happy the person is indifferent between them.
THE THEORY OF CONSUMER CHOICE 22

Indifference curve

B A

I1

Quantity of Fish

Four Properties of Indifference Curves

1. Indifference curves are downwardsloping.
Quantity of Mangos

Indifference curve

If the quantity of fish is reduced, the quantity of mangos must be increased to keep the person equally happy.

B A

I1

Quantity of Fish
THE THEORY OF CONSUMER CHOICE 23

Four Properties of Indifference Curves

2. Higher indifference curves are preferred to lower ones.
Quantity of Mangos

Indifference curves

He prefers every bundle on I2 (like C) to every bundle on I1 (like A). He prefers every bundle on I1 (like A) to every bundle on I0 (like D).
THE THEORY OF CONSUMER CHOICE 24

D A

I2 I1

I0
Quantity of Fish

Four Properties of Indifference Curves

3. Indifference curves cannot cross.
If it did, it violates the transitivity assumption. A B both are onI1 A C - both are on I4
Therefore, B

Quantity of Mangos

Indifference curves

B C A

C not true

because C > A

I1 I4

Quantity of Fish
THE THEORY OF CONSUMER CHOICE 25

Four Properties of Indifference Curves

4. Indifference curves are bowed inward.
Quantity of Mangos

He is willing to give up more mangos for a fish if he has few fish (A) than if he has many (B).

6
1 2 B

I1
Quantity of Fish

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26

The Marginal Rate of Substitution

Quantity Marginal rate of of Mangos substitution (MRS): the rate at which a consumer is willing to trade one good for another.

MRS = is the negative of the slope of Aindifference curve

MRS = 6 1

MRS is the amount of mangos he would substitute for another fish. MRS falls as you move down along an indifference curve.
THE THEORY OF CONSUMER CHOICE 27

MRS = 2

I1
Quantity of Fish

One Extreme Case: Perfect Substitutes

Perfect substitutes: two goods with straightline indifference curves, constant MRS Example: nickels & dimes Consumer is always willing to trade two nickels for one dime.

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Another Extreme Case: Perfect Complements

Perfect complements: two goods with right-angle indifference curves Example: Left shoes, right shoes {7 left shoes, 5 right shoes} is just as good as {5 left shoes, 5 right shoes}

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29

Less Extreme Cases: Close Substitutes and Close Complements

Quantity of Pepsi

Indifference curves for close substitutes are not very bowed

Quantity of hot dog buns

Indifference curves for close complements are very bowed

Quantity of Coke

Quantity of hot dogs

The Budget Constraint: What the Consumer Can Afford

Example: Hurley divides his income between two goods: fish and mangos. Budget constraint: the limit on the consumption bundles that a consumer can afford
Shift in the budget constraint:

1. change in income
2. change in the price/s of the goods

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31

ACTIVE LEARNING

Budget Constraint
Hurleys income: $1200 Prices: PF = $4 per fish, PM = $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy?
B. If Hurley spends all his income on mangos,

how many mangos does he buy?

C. If Hurley buys 100 fish, how many mangos can he

buy?
D. Plot each of the bundles from parts A C on a

graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots. 32

ACTIVE LEARNING

1
D. Hurleys budget constraint shows the bundles he can afford.
C

Answers
Quantity of Mangos

A. $1200/$4 = 300 fish B. $1200/$1 = 1200 mangos C. 100 fish cost $400, $800 left buys 800 mangos

A
Quantity of Fish

From C to D,

The Slope of the Budget Constraint

Quantity of Mangos

rise = 200 mangos

run = +50 fish

Slope = 4

C
D

Hurley must give up 4 mangos to get one fish.

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34

Quantity of Fish

The Slope of the Budget Constraint

The slope of the budget constraint equals
the rate at which Hurley can trade mangos for fish
the opportunity cost of fish in terms of mangos the price of price of fish: relative fish $4 4 mangos per fish price of mangos $1

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35

ACTIVE LEARNING

Budget constraint, continued.

Show what happens to Hurleys budget constraint if:

A. His income falls to $800. B. The price of mangos rises to PM = $2 per mango

36

ACTIVE LEARNING

2
A fall in income shifts the budget constraint down.

Answers, part A
Now, Hurley can buy
$800/$4 = 200 fish or $800/$1 = 800 mangos or any combination in between.
Quantity of Mangos

Quantity of Fish

ACTIVE LEARNING

2
An increase in the price of one good pivots the budget constraint inward.

Answers, part B
Hurley can still buy 300 fish.
Quantity of Mangos

But now he can only buy $1200/$2 = 600 mangos.

Notice: slope is smaller, relative price of fish is now only 2 mangos.

Quantity of Fish

Optimization: What the Consumer Chooses

A is the optimum: the point on the budget constraint that touches the highest possible indifference curve. Hurley prefers B to A, but he cannot afford B. Hurley can afford C and D, but A is on a higher indifference curve.
THE THEORY OF CONSUMER CHOICE 39

Quantity of Mangos

1200

The optimum is the bundle Hurley most prefers out of all the bundles he can afford.
B

600

A
C D
150 300 Quantity of Fish

Optimization: What the Consumer Chooses

At the optimum, slope of the indifference curve equals slope of the budget constraint: MRS = PF/PM marginal value of fish (in terms of mangos)
THE THEORY OF CONSUMER CHOICE

Quantity of Mangos

1200

600

price of fish (in terms of mangos)

40

150

300

Quantity of Fish

The Effects of an Increase in Income

Quantity of Mangos

An increase in income shifts the budget constraint outward. If both goods are normal, Hurley buys more of each.
B

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41

Quantity of Fish

ACTIVE LEARNING 3

Inferior vs. normal goods

An increase in income increases the quantity

demanded of normal goods and reduces the quantity demanded of inferior goods. Suppose fish is a normal good but mangos are an inferior good. Use a diagram to show the effects of an increase in income on Hurleys optimal bundle of fish and mangos.
42

ACTIVE LEARNING 3

Answers
If mangos are inferior, the new optimum will contain fewer mangos.

Quantity of Mangos

Quantity of Fish

43

The Effects of a Price Change

Initially, PF = $4
Quantity of Mangos 1200 initial optimum new optimum 600 500

PM = $1
PF falls to $2 budget constraint rotates outward,

Hurley buys more fish and fewer mangos.

150

300 350

600

Quantity of Fish

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44

The Income and Substitution Effects

A fall in the price of fish has two effects on Hurleys optimal consumption of both goods.

Income effect
A fall in PF boosts the purchasing power of Hurleys income, allows him to buy more mangos and more fish.

Substitution effect
A fall in PF makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish.

Notice: The net effect on mangos is ambiguous.

THE THEORY OF CONSUMER CHOICE

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The Income and Substitution Effects

Initial optimum at A.
Quantity of Mangos

PF falls.
Substitution effect: from A to B, buy more fish and fewer mangos. Income effect: from B to C, buy more of both goods.
THE THEORY OF CONSUMER CHOICE 46

In this example, the net effect on mangos is negative.

A B

Quantity of Fish

ACTIVE LEARNING

The substitution effect in two cases Do you think the substitution effect would be bigger for substitutes or complements?

Draw an indifference curve for Coke and Pepsi, and,

on a separate graph, one for hot dogs and hot dog buns.

On each graph, show the effects of a relative price

change (keeping the consumer on the initial indifference curve).

47

ACTIVE LEARNING

Answers
But the substitution effect is bigger changes by In both graphs, the relative price for substitutes than complements. the same amount.
Quantity of Pepsi Quantity of hot dog buns

A A B

Quantity of Coke

Quantity of hot dogs

Deriving Hurleys Demand Curve for Fish

B:A: WhenFPF $2, Hurley demands 350 fish. When P = = $4, Hurley demands 150 fish.
Quantity of Mangos Price of Fish

$4

B
$2

DFish
150 350 Quantity of Fish
49

150

350

Quantity of Fish

Application 1: Giffen Goods

Do all goods obey the Law of Demand? Suppose the goods are potatoes and meat, and potatoes are an inferior good. If price of potatoes rises, substitution effect: buy less potatoes income effect: buy more potatoes If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded.
THE THEORY OF CONSUMER CHOICE 50

Application 1: Giffen Goods

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Application 2: Wages and Labor Supply

Budget constraint Shows a persons tradeoff between consumption and leisure. Depends on how much time she has to divide between leisure and working. The relative price of an hour of leisure is the amount of consumption she could buy with an hours wages.

Indifference curve Shows bundles of consumption and leisure that give her the same level of satisfaction.
THE THEORY OF CONSUMER CHOICE 52

Application 2: Wages and Labor Supply

At the optimum, the MRS between leisure and consumption equals the wage.

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Application 2: Wages and Labor Supply

An increase in the wage has two effects on the optimal quantity of labor supplied.
Substitution effect (SE): A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e., increases quantity of labor supplied. Income effect (IE): With a higher wage, she can afford more of both goods. She chooses more leisure, i.e., reduces quantity of labor supplied.
THE THEORY OF CONSUMER CHOICE 54

Application 2: Wages and Labor Supply

For this person, SE > IE So her labor supply increases with the wage

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Application 2: Wages and Labor Supply

For this person, SE < IE So his labor supply falls when the wage rises

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Could This Happen in the Real World???

Cases where the income effect on labor supply is very strong:

Over last 100 years, technological progress has increased labor demand and real wages. The average workweek fell from 6 to 5 days. When a person wins the lottery or receives an inheritance, his wage is unchanged hence no substitution effect. But such persons are more likely to work fewer hours, indicating a strong income effect.
THE THEORY OF CONSUMER CHOICE 57

CONCLUSION:

Do People Really Think This Way?

People do not make spending decisions by writing down their budget constraints and indifference curves. Yet, they try to make the choices that maximize their satisfaction given their limited resources. The theory is only intended as a metaphor for how consumers make decisions. It explains consumer behavior fairly well in many situations and provides the basis for more advanced economic analysis.
THE THEORY OF CONSUMER CHOICE 58