Demand Theory

Demand Theory
• Till Last class - Demand Analysis
• Demand is based on Consumer behavior
• Session Outline
• Consumer preferences – Assumptions
• Utility analysis
• Indifference curve, budget line and consumer equilibrium
The Consumer’s Optimization Problem
• What will be the consumer's general behavior w.r.t consumption?
• Consumer's Goal
• Individual consumption decisions are made with the goal of maximizing total
satisfaction from consuming various goods and services
• Subject to the constraint that spending on goods exactly equals the individual’s money income
Consumer Theory
• Assumes buyers are completely informed about:
• Range of products available
• Prices of all products
• Capacity of products to satisfy
• Their income
• Requires that consumers can rank all consumption bundles based on
the level of satisfaction they would receive from different units of
consumption.
Assumptions
• Nonsatiation
• More of a good is always preferred to less
• Completeness
• For every pair of consumption bundles, A and B, the consumer can
say one of the following:
• A is preferred to B
• B is preferred to A
• The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to C, then A must be preferred to C
Utility Theory
• Utility: Benefits consumers obtain from goods & services they consume is
utility.
• It is a numerical score representing the satisfaction that a consumer gets
from given consumption basket.
• For example : If buying 3 copies of books give more happiness than
buying a shirt, it can be said that books give you more utility than shirt.
• Utility function: an equation that shows an individual perception of the
level of utility that would be attained from consuming each conceivable
bundle of goods.
U = F (X,Y)
Utility Analysis
• Cardinalist approach: Utility can be measured in subjective units.
• Ordinalist approach: Utility can not be measured , but can only ranked
in order of preference.
 Measurement of Utility : Example

Measuring utility in“utils” (Cardinal) Measuring utility by comparison (Ordinal):

• Jack derives 10 utils from having • Jill prefers a burger to a slice of
one slice of pizza but only 5 utils pizza and a slice of pizza to a
from having a burger. hotdog.
Total and Marginal Utility
• 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
• Marginal utility (MU): 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.
Assumptions for TU Curve
• As the quantity consumed per period increases, total utility increases
at a decreasing rate
• What total utility reaches the maximum, it attains satiation quantity
• Total utility declines if more quantity consumed after satiation
quantity
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.
• Law of Diminishing Marginal Utility - Conditions
• The unit of consumption must be a standard one
• Consumption must be continuous
• The tastes and preferences of the consumer should remain unchanged during the course
of consumption
• The goods should be Normal and not Addictive in nature
Total and Marginal Utility
• TU, in general, increases with Q
• At some point, TU can start falling with Q
(see Q = 6)
• If TU is increasing, MU > 0
• From Q = 1 onwards, MU is declining
==>principle of diminishing marginal utility
==>As more and more of a good are
consumed, the process of consumption
will (at some point) yield smaller and
smaller additions to utility
Indifference Curve Analysis
• The starting point for indifference analysis is
to identify possible baskets of goods and
services which yield the same utility
(usefulness, or satisfaction) to consumers.
• It is assumed that individuals, faced with a
budget constraint, will choose the basket
that maximises their total utility
• Indifference curve - Locus of points
representing different bundles of goods,
each of which yields the same level of total
utility
• A curve that defines the combinations of 2 or
more goods that give a consumer the same
level of satisfaction
Indifference Curve Properties
• IC will be downward sloping : If they
sloped upward, they would violate the
assumption that more is preferred to less
• An IC must be convex to the origin :As
more of one good is consumed, a
consumer would prefer to give up fewer
units of a second good to get additional
units of the first one. As food becomes
less scarce, he/she would give up less of
clothing for an additional food.
• Two ICs can not intersect each other
• Higher Indifference curve gives higher
level of satisfaction
Marginal Rate of Substitution
• MRS shows the rate at which one good can be substituted for another
while keeping utility constant
– Negative of the slope of the indifference curve
– Diminishes along the indifference curve as X increases & Y
decreases
– Ratio of the marginal utilities of the goods
Marginal Rate of Substitution

The MRS diminishes along the indifference curve

– As one consumes more of good X they will be less willing to give up
more of good Y.
– The relative price of good Y increases.
Types of Indifference curves
• Perfect Substitutes • Perfect Complements
Consumer’s Budget Line
• The budget line for a consumer
shows all possible combinations
of goods that can be bought at a
specific income level (budget)
and with specific prices of goods
Changes in the Budget Line
• Changes in Income • Changes in Price
Consumer Equilibrium
• A consumer behaves rationally
and would always aim to
maximize utility , given income
and prices of goods in the
consumption basket.
• Is at a point where the budget
line is tangent to the highest
attainable indifference curve by
the consumer subject to budget
constraint
Consumer's Objective
• to maximize his/her utility subject to income constraint
• For Ex:
2 goods (X, Y)
Prices Px, Py are fixed
Consumer’s income (I) is given
Utility Maximization
 Optimality requires PX/PY = MRSXY
MRS= (MUX/MUY.)
 Optimality requires MUX/PX = MUY/PY
Consumer Equilibrium
The equilibrium consumption bundle is
the affordable bundle that yields the
highest level of satisfaction.
Recap
• Demand Theory - Consumer Behavior
• Utility - Measurement strategies
• Total and Marginal utility
• Diminishing Marginal Utility
• Indifference Curve Analysis
• Marginal Rate of Substitution
• Budget line
• Consumer Equilibrium
PRICE,INCOME AND SUBSTITUTION
EFFECTS
• A fall in the price of a good has two effects
• Consumers will tend to buy more of the good that has become cheaper and
less of those goods that are now relatively more expensive
• Because one of the goods is now cheaper, consumers enjoy an increase in
real purchasing power
• Income effect: Change in consumption of a good resulting from an increase in
purchasing power, with relative prices held constant.
• Substitution effect: Change in consumption of a good associated with a change
in its price, with the level of utility held constant

• Price Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2)

PRICE,INCOME AND SUBSTITUTION
EFFECTS
• The consumer is initially at A, on budget
line RS. When the price of food falls,
consumption increases by F1F2 as the
consumer moves to B.
• The substitution effect F1E (associated
with a move from A to D) changes the
relative prices of food and clothing but
keeps real income (satisfaction) constant.
• The income effect EF2 (associated with a
move from D to B) keeps relative prices
constant but increases purchasing power.
• Food is a normal good because the income
effect EF2 is positive
PRICE,INCOME AND SUBSTITUTION
EFFECTS
• When price of Y decrease from Rs 10 to Rs 5, holding the income
constant , quantity demanded of Y increases from 40 to 84. This
change in demand is Rs 44 is price effect.
• Price effect constitutes of income and substitution effect. The
substitution effects can be computed by forcing the consumer to the
same utility,( 100), by reducing the income suitably.
• So substitution effect is (70-40) = 30
• Now the income effect is (84-70) = 14
• Since the income effect is positive , the good can be classified as a
normal good
CONSUMER SURPLUS
• Consumer Surplus is the difference between the price that consumers
pay and the price that they are willing to pay.
• On a supply and demand curve, it is the area between the equilibrium
price and the demand curve
• Consumer surplus is the total benefit from the consumption of a
product, less the total cost of purchasing it.
CONSUMER SURPLUS
• Here, the consumer surplus
associated with six concert
tickets (purchased at Rs14 per
ticket) is given by the yellow-
shaded area
CONSUMER SURPLUS
• For the market as a whole,
consumer surplus is measured
by the area under the demand
curve and above the line
representing the purchase price
of the good
Consumer Surplus and Demand
• When added over many individuals, it measures the aggregate benefit
that consumers obtain from buying goods in a market.
• When we combine consumer surplus with the aggregate profits that
producers obtain, we can evaluate both the costs and benefits of
alternative market structures and public policies.
Change in Consumer Surplus: Price Increase
Significance
• In competitive markets, firms have to keep prices relatively low,
enabling consumers to gain consumer surplus. If markets were not
competitive, the consumer surplus would be less and there would be
greater inequality.
• A lower consumer surplus leads to higher producer surplus and
greater inequality.
• Consumer surplus enables consumers to purchase a wider choice of
goods.