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Consumer Behavior and Demand Analysis

Consumer Behavior
Any market has two sides: The demand: resulting from the behavior of the buyers in the market; and the supply: resulting from the behavior of the sellers in the market. The behavior of either side can be described with appropriate curves: The Demand Curve and the Supply Curve. Why do people demand goods and services?

Receive satisfaction or pleasure from consuming the good. Economists terms this satisfaction utility

Consumer

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.

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.

Approaches to consumer behavior

Cardinal Approach

Traditional theory (By Marshall) Examines consumer behavior on the basis of utility consideration. Utility in terms of number
Revealed preference theory Modern Theory (Hicks) Ranking of options for a particular commodity Indifference Curve Analysis

Ordinal approach

Cardinal Approach

Law of Diminishing marginal Utility

Other things remain the same, as a consumer increases his consumption of goods, the Marginal Utility eventually starts declining. If MU diminishes then demand will also decrease.

TU, MU and profit

Total Utility (TU) - relates consumption of a good to the utility derived from consuming a good. It is the sum of marginal utilities. (This could be many units of a good) Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit.

MU = DTU / D Q consumed of a good

Utility Schedule
Quantity 2 3 4 5 6 Total Utility 8 18 26 31 33 Marginal Utility 0 10 8 5 2

7
8

33
32

0
-1

Diagram of TU and MU
35 30 25
TU and MU

20 15 10 5 0 -5 Quantity

Marginal Utility Total Utility

Some facts of life: Limited income Opportunity cost of making a choice: Buying a unit will leave the consumer with less money to buy other things. In fact, consumers compare the (expected) utility derived from one additional money spent on one good to the utility derived from one additional money spent on another good.

Findings

Shape of MU Eventually downward sloping

Law of diminishing marginal utility

Positive always

Rational behavior

Consumer only purchases a good if they get some positive utility from it.

Findings contd

Shape of TU Positive slope

Consumer only purchases a good if gets some positive amount of utility (rational behavior)

Slope gets flatter as Q increases

Law of diminishing marginal utility

Consumer surplus

Money measure of the value the consumers get from a good or service, net of the amount paid.
Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good. Example:

Im willing to pay $6 for a case of soda Soda is on sale for $5 a case Consumer surplus = $1

Consumer surplus
P $9
This is the Consumer Surplus for the second case of soda

$7
$5 D 0 1 2

Ordinal utility
Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Curves further from origin represent higher utility levels

Assumptions of Indifference curve


Indifference curve analysis is based on the following assumptions: 1. Transitivity: It is assumed that the combinations are continuous to form a curve. The combinations between two tested sets are given. 2. Ordinality: The indifference curve analysis considers ordinal measure of utility. That is utility is compared but not qualified. 2. Rationality: The consumer is rational. He always prefers higher satisfaction to the lower and he knows all the combinations giving him same satisfaction or different satisfactions. 3. Convexity: A convex indifference curve represents the consumer behavior. The convex IC shows the utility behavior with out actually measuring utility in cardinal terms. 4. Scale of preference: On a series of indifference curves the consumer has a preference increases from low to high. The consumer always prefers higher satisfaction to lower. This is called the scale of preference.

Properties of Indifference curve

Indifference curve towards axis represents lower level of satisfaction

Properties....

Indifference curve never touches the axis

IC is a downward sloping curve

On a IC Marginal rate of substitution decreases

IC is convex to the origin

IC curves need not to be parallel IC curves do not intersect.

Combinations 1 2 3

Mangoes 10 8 6

Oranges 2 3 4

4
5

4
2

5
6

Budget line

The amount of goods a consumer can buy is constrained by the income. This budgetary constraint can be shown by the budget line.

A (Pm*Qm) 20*5 20*4 20*3

B (Po*Qo) 10*0 10*1 10*2

A+B (Total Income) 100 100 100

20*2
20*1

10*3
10*4

100
100

Consumer equillibrium
The consumer is in the equilibrium where the indifference curve is tangent to the budget line. There are two conditions of consumer equilibrium

a. Necessary Condition: Tangency is a necessary condition. It is case of optimizing satisfaction. In the diagram is a necessary condition. Yet it is not the equilibrium.
b. Sufficient condition: Tangency + convexity is sufficient condition. Tangency represents mathematical optimization and convexity denotes consumer behavior. In the diagram E2 is necessary condition. It fulfills tangency as well as convexity.

Consumer surplus

Anything above the consumer equilibrium but with in the budget line is consumer surplus.

DEMAND ANALYSIS

Demand defined

Demand is the willingness and ability of buyers to purchase different quantities of a good, at different prices, during a specific time period. Both willingness and ability must be present; if either is missing, there is no demand. The demand curve is just the description of the relationship between quantity and price.

Determinants of Demand

Income Preferences Prices of related goods Number of buyers Future price

Income

As a persons income changes, he or she may buy more or less of a certain good. If a persons income and demand change in the same direction, the good is a normal good. If income and demand go in opposite directions, the good is an inferior good. If demand does not change even though income does, the good is a neutral good.

Preferences

Changes in preferences cause changes in demand.

Prices of Related Goods

When two goods are substitutes, the demand for one moves in the same direction as the price of the other.

If the price of coffee increases, the demand for tea increases as people substitute tea for the higher-priced coffee.

When two goods are complements, the demand for one moves in the opposite direction of the price of the other.

As the price of tennis rackets rises, the demand for tennis balls decreases.

Number of Buyers

A change in the number of buyers, either an increase or a decrease, can change demand.

Future Price

Buyers expectations of future prices can cause them to buy now or wait to buy. Both actions affect current demand. The only factor that affects quantity demanded is price.

Other determinants

Availability of substitutes Share of consumers budget spent on the good. A matter of time Some elasticity estimates.

Demand Function

A table, graph, or an equation that shows how quantity demanded is related to product price, holding constant the five other variables that influence demand. A demand function can be expressed as:

Which means that the quantity demanded is a function of the price of the good, holding all other variables constant. It is expressed in the form of a linear demand equation.

Demand function contd

Where

Q = Quantity purchased of a good or service P = Price of the good or service M = Consumers income Pr = Prices of related goods N = Number of buyers

Law of demand

The quantity purchased of a good or service is inversely related to the price, all other things being equal. Thus, the
higher the price, the smaller the quantity demanded. If P then Qd If P then Qd

Quantity Demanded vs. Demand

Quantity demanded
The quantities of a good or service that people will purchase at a specific price over a given period of time

Demand
Graph of the total quantities of a good or service that purchasers will buy at different prices at a given time

Types of Demand

Individual demand
The quantity of a good or service that an individual or firm stands ready to buy at various prices at a given time

Market demand
The sum of the individual demands in the marketplace

Demand Curve
AED

1.55

1.50
1.45 1.40 1.35

Price per Hour

1.30
1.25 1.20 1.15 1.10 1.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13

Quantity (Number of hours per Day )

Demand Schedule
Price Quantity Demanded per Pizza per Week (millions)

a b c d e

$15 12 9 6 3

8 14 20 26 32

Demand Curve for Pizza


$15 Price per pizza 12 a

b
c d e D 8 14 20 26 32 Millions of pizzas per week

9
6 3 0

Individual Demand for Pizzas


A B C

$12 Price 8 4 1 2 3

$12
8 4

$12

dH

dB

8 4 1

dC

1 2 Pizzas (per week)

Market Demand for Pizzas


(d) Market demand for pizzas

dH + dB + dC = D $12 Price 8 4 1 2 3 6 Pizzas (per week)

Changes in Demand

Change in Quantity Demanded


Movement along the demand curve that occurs because the price of the product has changed

Change in Demand
Change in the amounts of the product that would be purchased at the same given prices; a shift in the entire demand curve

When Demand Changes, the Curve Shifts

When demand goes up, the demand curve shifts to the right. (Change in Demand) When demand goes down, the demand curve shifts to the left. (Change in Demand)

Elasticity of Demand

What is Elasticity of Demand?

Elasticity is another term in economics that sounds more difficult to understand than it really is. It measures how a price change affects the quantity of a particular good that people want to buy.

What types of elasticity are there?


Demand for a good can be elastic, inelastic, or unit-elastic. Elastic: a price change has a significant impact on the quantity demanded. Inelastic: there is a minor change in quantity demanded when the price changes. Unit-elastic: the impact of a price change is neutral that is, neither major nor minor.

How do we find out which type of demand is at work?

In all cases, the type of demand has to do with the relationship between the percentage change in quantity demanded and the percentage change in price. When we divide the percentage change in quantity demanded by the percentage change in price, we get a number that is greater than 1, less than 1, or exactly 1.

Computing the Elasticity of Demand

Elasticity of demand measures the percentage change in quantity demanded divided by percentage change in price.

Elasticity of demand

Percentage change in quantity demanded Percentage change in price

How do we find out which type of demand is at work? (cont.)

If the answer to our division problem is greater than 1, the demand is elastic. If the answer is less than 1, the demand is inelastic. If the answer is exactly 1, the demand is unitelastic.

Elasticity of Demand
Mythical demand curve

(a)

Quantity/ time

Perfectly inelastic: An increase in price results in no change in consumers purchases. The vertical demand curve is mythical as the substitution and income effects prevent this from happening in the real world.

Relatively inelastic: A percent increase in price results in a smaller % reduction in sales. The demand for cigarettes has been estimated to be highly inelastic.
(b)

Demand for Cigarettes

Quantity/ time

Elasticity of Demand
Demand curve of unitary elasticity

(c)

Quantity/ time

Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price. A decreasing slope results. Sales revenue (price times quantity) is constant.

Example :1

Suppose the quantity demanded goes down by 15 percent and the price goes up by 10 percent. What type of demand do we have? We divide 15 percent by 10 percent and get 1.5. Since the number is greater than one, the demand is elastic.

Example: 2

What if the quantity demanded goes down by 5 percent and the price goes up by 10 percent? We divide 5 percent by 10 percent and get 0.5. Since the answer is less than 1, the demand is inelastic.

Example: 3

What if the quantity demanded goes down by 10 percent and the price goes up by 10 percent? We divide 10 percent by 10 percent and get 1. Obviously 1 is equal to 1, so the demand is unit-elastic.

Price elasticity of demand

Price elasticity reveals the responsiveness of the amount purchased to a change in price.

Price Elasticity of Demand

Price elasticity reveals the responsiveness of the amount purchased to a change in price.
Price Elasticity of demand
% Change in quantity demanded = % Change in Price

%D Q %D P

(Q0 Q1 ) = (Q0 Q1 ) 2

( P0 P ) 1 ( P0 P ) 2 1

- or put more simply -

(Q0 Q1 ) (Q0 Q 1) = ( P0 P1 ) ( P0 P1)

Price Elasticity Numerical Application


Suppose Trina bakes specialty cakes. She can sell 50 specialty cakes per week at $7 a cake, or 70 specialty cakes per week at $6 a cake. What is the demand elasticity for Trinas cakes?
(50 70 ) 20 Percent change in 33 .33 % quantity demanded: (50 70 ) 2 60

Percent change in price:

( 7 6) 1 15 .38 % (7 6) 2 6.5

- Recall Price Elasticity of demand =

(Q0 Q1 ) (Q0 Q1 ) 2

( P0 P ) 1 ( P0 P ) 2 1

Determinants of Price Elasticity of Demand

Availability of substitutes

When good substitutes for a product are available, a rise in price induces many consumers to switch to another product. The greater the availability of substitutes, the more elastic demand will be.

Share of total budget expended on product

As the share of the total budget spent on the product increases, demand is more elastic.

Time and Demand Elasticity

If the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run.

Thus, demand for most products will be more elastic in the long run than in the short run. This relationship is sometimes referred to as the second law of demand.

Income Elasticity

Income elasticity indicates the responsiveness of a products demand to a change in income.


Income Elasticity of demand

% Change in quantity demanded % Change in Income

A normal good is a good with a positive income elasticity of demand.

As income expands, the demand for normal goods will rise.

Goods with a negative income elasticity are called inferior goods.

As income expands, the demand for inferior goods will decline.

What Determines Elasticity of Demand?

Four factors affect the elasticity of demand: Number of substitutes Luxuries versus necessities Percentage of income spent on the good Time

Number of Substitutes

When there are few substitutes for a good, the quantity demanded is unlikely to change much if the price rises. Therefore, the demand for the good is likely to be inelastic. When there are many substitutes for a good, the opposite is true: the demand tends to be elastic.

Luxuries versus Necessities

Demand for necessities tends to be inelastic because people need those goods even if prices rise. Demand for luxuries tends to be elastic because people will often do without those goods if prices rise.

Percentage of Income Spent on the Good

If a good requires a large percentage of a persons income, demand for it tends to be elastic. Demand for goods that require a small percentage of a persons income tends to be inelastic.

Time

When consumers have little time to respond to a price change, demand is usually inelastic. When they have more time to respond, demand is usually elastic.

Relationship Between Elasticity and Revenue

Elastic demand and an increase in price lead to a decrease in total revenue. Elastic demand and a decrease in price lead to an increase in total revenue. Inelastic demand and an increase in price lead to an increase in total revenue. Inelastic demand and a decrease in price lead to a decrease in total revenue.

Demand Estimation and Forecasting