The Demand Side of theThe Demand Side of theMarketMarket

Econ Dept, UMR

Presents

u Utility Theory

u Consumer Surplus

u Elasticity

StarringStarring

FeaturingFeaturing

uuThe MU/P RuleThe MU/P RuleuuThe Meaning of ValueThe Meaning of ValueuuFour Elasticities:Four Elasticities:

vvPrice Elasticity of DemandPrice Elasticity of DemandvvIncome ElasticityIncome ElasticityvvCross Price ElasticityCross Price ElasticityvvPrice Elasticity of SupplyPrice Elasticity of Supply

uuThe Elasticity-TR relationshipThe Elasticity-TR relationship

In Three PartsIn Three Parts

Consumer Choice TheoryConsumer Choice Theory

Consumer SurplusConsumer Surplus

ElasticityElasticity

Consumer Choice TheoryConsumer Choice Theory

Income/Substitution EffectsIncome/Substitution Effects

Utility TheoryUtility Theory

Part 1

Assumptions underlying theAssumptions underlying theConsumer choice model:Consumer choice model:uu Consumers buy competitively, that isConsumers buy competitively, that is

they can buy as much as they want at athey can buy as much as they want at agiven pricegiven price

uu Consumers have limited moneyConsumers have limited moneyincomes and sufficient information toincomes and sufficient information tomake informed choicesmake informed choices

uu Consumers are rationalConsumers are rationaluu Consumers seek to maximize their totalConsumers seek to maximize their total

utility or satisfactionutility or satisfaction

Consumers Have to ChooseConsumers Have to ChooseWhat They Want With TheirWhat They Want With TheirLimited IncomesLimited Incomes

?? ????

Hot LinksHot Links

uu USADATAUSADATA

Jump to USADATA and Click on “FreeExamples” to see some data on your buyingpatterns

Review -- the determinants ofReview -- the determinants ofconsumer demand (PINTE):consumer demand (PINTE):uu PP: The : The price of the productprice of the product, and the, and the

prices of substitutes and complementsprices of substitutes and complementsavailable to the consumeravailable to the consumer

uu II: The : The incomeincome available to the available to theconsumerconsumer

uu NN: The : The numbernumber of consumers of consumersuu TT: The consumer’s : The consumer’s tastestastes and and

preferencespreferencesuu EE: The consumer’s : The consumer’s expectationsexpectations about about

future income, wealth, and pricesfuture income, wealth, and prices

Basic Demand TheoryBasic Demand Theoryuu Law of Demand - The rule thatLaw of Demand - The rule that

consumers buy more at low prices thanconsumers buy more at low prices thanthey do at high prices.they do at high prices.

uu The Law may be argued from anThe Law may be argued from ananalysis of:analysis of:vv The Income/Substitution EffectThe Income/Substitution Effect of a Price of a Price

Change, orChange, orvv Utility TheoryUtility Theory - A theory of consumer - A theory of consumer

behavior in which people buy goods basedbehavior in which people buy goods basedon the satisfaction they expect to deriveon the satisfaction they expect to derivefrom those goods.from those goods.

First, We’ll Look at the IncomeFirst, We’ll Look at the Incomeand Substitution Effect of aand Substitution Effect of aPrice ChangePrice Change

uu Price changes affect consumers in twoPrice changes affect consumers in twoways:ways:vv Income effectsIncome effects: Consumption changes: Consumption changes

because purchasing power changes.because purchasing power changes.vv Substitution effectsSubstitution effects: Consumption: Consumption

changes because opportunity costs change.changes because opportunity costs change.

Income Effect of a Price ChangeIncome Effect of a Price Change

uu When the price of a product When the price of a product fallsfalls, a, aconsumer has consumer has moremore purchasing power purchasing powerwith the same amount of incomewith the same amount of income

uu When the price of a product When the price of a product risesrises, a, aconsumer has consumer has lessless purchasing power withpurchasing power withthe same amount of incomethe same amount of income

uu More purchasing power will More purchasing power will increaseincrease the thedemand for demand for normalnormal goods and goods and decreasedecreasethe demand for the demand for inferiorinferior goods goods

Normal vs Inferior vs GiffenNormal vs Inferior vs GiffenGoodsGoods

uu Normal GoodsNormal Goods - Those that consumers buy - Those that consumers buymore of as their real incomes rise and less ofmore of as their real incomes rise and less ofas their real income fallsas their real income falls

uu Inferior GoodsInferior Goods - Those goods consumers buy - Those goods consumers buymore of as their income falls and less of asmore of as their income falls and less of astheir income risestheir income rises

uu Giffen GoodsGiffen Goods - Those - Those inferiorinferior goods with an goods with anincome effect that moves in the sameincome effect that moves in the samedirection as price and for which the incomedirection as price and for which the incomeeffect is larger than the substitution effecteffect is larger than the substitution effect..

Substitution Effects of a PriceSubstitution Effects of a PriceChangeChange

uu When the price of a product When the price of a product fallsfalls, that, thatproduct becomes product becomes moremore attractive attractiverelative to potential substitutesrelative to potential substitutes

uu When the price of a productWhen the price of a product risesrises, that, thatproduct becomes product becomes lessless attractive relativeattractive relativeto potential substitutesto potential substitutes

uu The substitution effect implies theThe substitution effect implies thedemand curve will be downward slopingdemand curve will be downward sloping

Income vs. Substitution EffectIncome vs. Substitution Effect

uu Income EffectIncome Effect - The change in quantity - The change in quantitydemanded of a good due to a change in realdemanded of a good due to a change in realincome caused by a change in the price of aincome caused by a change in the price of agoodgood

uu Substitution EffectSubstitution Effect - The change in the quantity - The change in the quantitydemanded of a good resulting from a change indemanded of a good resulting from a change inits price relative to the price of other goodsits price relative to the price of other goods

uu Usually, Usually, normallynormally,the two effects work,the two effects worktogether--increase in Qtogether--increase in QDD when P falls and when P falls anddecrease in Qdecrease in QDD when P increases when P increases

Income, Substitution Effect of aIncome, Substitution Effect of aFall in Price of a Fall in Price of a NormalNormal Good Good

Price Falls

Real Income Increases

QD IncreasesSubstitution Effect

IncomeEffect

P

Q/t

D

Income, Substitution Effect of aIncome, Substitution Effect of aFall in Price of an Fall in Price of an InferiorInferior** Good Good

Price Falls

Real Income Increases

QD DecreasesSubstitutionSubstitutionEffect

IncomeEffect

QD Increases

QD IncreasesTotal Effect =

*Inferior, but not a GiffenGood

P

Q/t

D

Income, Substitution Effect of aIncome, Substitution Effect of aFall in Price of a Fall in Price of a GiffenGiffen Good Good

Price Falls

Real Income Increases

QD DecreasesSubstitutionSubstitutionEffect

IncomeEffect

QD Increases

QD DecreasesTotal Effect =

P

Q/t

D

uu Both effects work to explain the law ofBoth effects work to explain the law ofdemanddemand

uu Only in the case of inferior goods is anOnly in the case of inferior goods is anupward sloping demand possibleupward sloping demand possible

uu Even with inferior goods, the substitutionEven with inferior goods, the substitutioneffect will outweigh the income effect unlesseffect will outweigh the income effect unlessvv the good is strongly inferior and occupies a largethe good is strongly inferior and occupies a large

portion of a person’s budgetportion of a person’s budgetvv the market is dominated by persons for whom thethe market is dominated by persons for whom the

good is a Giffen goodgood is a Giffen good

uu Economists are still looking for a Giffen goodEconomists are still looking for a Giffen good

Summary: The Law of Demand andthe Income - Substitution Effect

Now, lets look at the law ofNow, lets look at the law ofdemand and consumerdemand and consumerchoice within the context ofchoice within the context ofUtility TheoryUtility Theory

uu We need to establish some basicWe need to establish some basicconceptsconceptsvv The budget constraintThe budget constraintvv Total and Marginal UtilityTotal and Marginal Utilityvv The common sense of the MU/P ruleThe common sense of the MU/P rule

Budget ConstraintBudget Constraintuu The limits imposed onThe limits imposed on

consumer choices by income,consumer choices by income,wealth, and product priceswealth, and product prices

Showing the BudgetShowing the BudgetConstraint GraphicallyConstraint Graphically

B

I = Income per period = $200I = Income per period = $200

PPXX = Price of Good X = $10 = Price of Good X = $10

PPYY = Price of Good Y = $5 = Price of Good Y = $5

X/t

Y/t

20

40 = I/PY

= I/PX

Slope = - 40/20 = - (I/PSlope = - 40/20 = - (I/PYY)/(I/P)/(I/PXX))

= - P = - PXX/P/PYY

Showing A Decrease in IncomeShowing A Decrease in Income

B

I = Income per period = $200I = Income per period = $200

PPXX = Price of Good X = $10 = Price of Good X = $10

PPYY = Price of Good Y = $5 = Price of Good Y = $5

Slope = - 40/20 = - (I/PSlope = - 40/20 = - (I/PYY)/(I/P)/(I/PXX))

= - P = - PXX/P/PYY

20

40 = I/PY

= I/PX

X/t

Y/t

New Income = $100New Income = $100

20

10Parallel shift inward,Parallel shift inward,slope doesn’t changeslope doesn’t change

B

I = Income per period = $200I = Income per period = $200

PPXX = Price of Good X = $10 = Price of Good X = $10

PPYY = Price of Good Y = $5 = Price of Good Y = $5

Slope = - 40/20 = - (I/PSlope = - 40/20 = - (I/PYY)/(I/P)/(I/PXX))

= - P = - PXX/P/PYY

20

40 = I/PY

= I/PX

X/t

Y/t

Both Prices DoubleBoth Prices Double

20

10Parallel shift inward, slope doesn’t changeParallel shift inward, slope doesn’t changesince since relativerelative prices didn’t change prices didn’t change

Showing A Change in PricesShowing A Change in Prices

Showing A Change in Showing A Change in AA Price Price

B

I = Income per period = $200I = Income per period = $200

PPXX = Price of Good X = $10 = Price of Good X = $10

PPYY = Price of Good Y = $5 = Price of Good Y = $5

PPY2Y2 = New Price of Good Y = = New Price of Good Y =$10$10

20

40 = I/PY

= I/PX

X/t

Y/t

Price of Y DoublePrice of Y Double

20

10Rotation from the X axis, slope changes sinceRotation from the X axis, slope changes sincerelativerelative prices change prices change

Slope = - 20/20Slope = - 20/20

= -(P = -(PXX/P/PY2Y2)/(I/P)/(I/PXX) = - P) = - PXX/P/PY2Y2

The basis of choice: UtilityThe basis of choice: Utility

uu The budget constraint showsThe budget constraint showsus the combinations of twous the combinations of twogoods that a consumer goods that a consumer CANCANbuybuy

uu What else do we need to knowWhat else do we need to knowto determine what theto determine what theconsumer consumer WILLWILL buy? buy?

UtilityUtility

uu The satisfaction, or reward, aThe satisfaction, or reward, aproduct yields relative to itsproduct yields relative to itsalternativesalternatives

uu Impossible to measureImpossible to measureuu Cannot be compared across peopleCannot be compared across peopleuu Helps us to better understandHelps us to better understand

consumer choiceconsumer choice

Some Definitions for UtilitySome Definitions for UtilityTheoryTheory

uu Total utilityTotal utility is the total amount of is the total amount ofsatisfaction obtained fromsatisfaction obtained fromconsumption of a good, service, orconsumption of a good, service, oractivityactivity

uu Marginal utilityMarginal utility is the is the additionaladditionalsatisfaction gained by thesatisfaction gained by theconsumption or use of consumption or use of one more unit one more unit ofofa good, service, or activitya good, service, or activity

uu UtilUtil is a unit of satisfaction used to is a unit of satisfaction used tosubjectively measure satisfactionsubjectively measure satisfaction

Ordinal Measures andOrdinal Measures andInterpersonal UtilityInterpersonal UtilityComparisonsComparisonsuu The actual number of utils doesn’tThe actual number of utils doesn’t

matter, just the relationship betweenmatter, just the relationship betweenthem.them.

uu For this reason, we can’t compare utilsFor this reason, we can’t compare utilsbetween people. We can only comparebetween people. We can only compareutils between goods, services, orutils between goods, services, oractivities for one person.activities for one person.

A Point to NoteA Point to Note

uu Utility comes from any activity thatUtility comes from any activity thatgives us happiness-viewing a sunset,gives us happiness-viewing a sunset,talking with a person we like, hiking atalking with a person we like, hiking amountainous trail, or munching amountainous trail, or munching acandy barcandy bar

uu For convenience, we refer toFor convenience, we refer to“consuming a good” but we mean any“consuming a good” but we mean anyactivity that we enjoyactivity that we enjoy

Total and Marginal UtilityTotal and Marginal Utility

uu Total UtilityTotal Utility (TU) - relates consumption of (TU) - relates consumption ofa good to the utility derived froma good to the utility derived fromconsuming a goodconsuming a good

uu Marginal UtilityMarginal Utility (MU) - the change in total (MU) - the change in totalutility when consumption of a goodutility when consumption of a goodchanges by one unitchanges by one unitvv MU = MU = ∆∆TU / TU / ∆∆ Q Q

Law of Diminishing MarginalLaw of Diminishing MarginalUtilityUtility

uu Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility - -as more of a good is consumed, theas more of a good is consumed, theadded utility (MU) decreases, ceterisadded utility (MU) decreases, ceterisparibus.paribus.

Law of Diminishing MarginalLaw of Diminishing MarginalUtilityUtility

uu ExampleExamplevv If I’m really hungry, I get a lot ofIf I’m really hungry, I get a lot of

satisfaction from first slice of pizzasatisfaction from first slice of pizzavv As I keep eating pizza, the satisfactionAs I keep eating pizza, the satisfaction

from the next slice would be less than thatfrom the next slice would be less than thatof the first sliceof the first slice

vv And the MU of the third slice less than thatAnd the MU of the third slice less than thatof the second sliceof the second slice

Notes on the Law ofNotes on the Law ofDiminishing MUDiminishing MU

uu As with Demand and Supply, Utility isAs with Demand and Supply, Utility isa Flow: A Time Period must bea Flow: A Time Period must bespecifiedspecified

uu The Law tells us that the Total UtilityThe Law tells us that the Total Utilitycurve will become “flatter” ascurve will become “flatter” asconsumption increasesconsumption increasesvv Slope of the total utility curve is equal toSlope of the total utility curve is equal to

marginal utilitymarginal utility

Marginal UtilityMarginal Utility

MU

Q/tMU

Shape of MUShape of MU

uu Downward slopingDownward slopingvv Law of diminishing marginal utilityLaw of diminishing marginal utility

uu Always positiveAlways positiveuu Rational behaviorRational behavior

vv Consumer only purchases a good if theyConsumer only purchases a good if theyget some positive utility from it.get some positive utility from it.

Total UtilityTotal Utility

TU

Q/t

TU

∆∆TUTU

∆∆QQ

MU = MU = ÎÎTU/ TU/ ÎÎQQ

Region of “toomuch fun”

Total Utility and MarginalTotal Utility and MarginalUtilityUtility

TU

Q/t

At B, MU = 0

∆∆TUTU∆∆QQ

MU = MU = ÎÎTU/ TU/ ÎÎQQ

More precisely, MU isMore precisely, MU isdefined at a point. Atdefined at a point. Atpoint A, MU = the slopepoint A, MU = the slopeof the TU curveof the TU curve

A

B

Shape of TUShape of TU

uu Positive slopePositive slopevv Consumer only purchases a good if getsConsumer only purchases a good if gets

some positive amount of utility (rationalsome positive amount of utility (rationalbehavior)behavior)

uu Slope gets flatter as Q increasesSlope gets flatter as Q increasesvv Law of diminishing marginal utilityLaw of diminishing marginal utility

Consumer EquilibriumConsumer Equilibrium

uu Now that we understand the conceptsNow that we understand the conceptsof utility theory - we will use them toof utility theory - we will use them toexplain how consumers make decisionsexplain how consumers make decisionsabout what to buyabout what to buy

Consumer EquilibriumConsumer Equilibriumuu How well we like something isHow well we like something is

encompassed in the concepts of totalencompassed in the concepts of totalutility and marginalutility and marginal

uu But I can’t afford to think about what IBut I can’t afford to think about what Ilike the most, I have to think about what Ilike the most, I have to think about what Ihave to give up as wellhave to give up as well

uu So if I want to maximize my utility, ISo if I want to maximize my utility, Idon’t just pick the thing that gives me thedon’t just pick the thing that gives me themost pleasure. I have to weigh the pricemost pleasure. I have to weigh the priceof the good in my decision as wellof the good in my decision as well

Allocating Income toAllocating Income toMaximize UtilityMaximize Utility

How can we use the informationHow can we use the informationon the budget set and utilityon the budget set and utilitytheorytheory to determine the utility to determine the utilitymaximizing bundle of goods andmaximizing bundle of goods andservicesservices??

Utility-Maximizing RuleUtility-Maximizing Ruleuu A utility maximizing consumer allocates hisA utility maximizing consumer allocates his

or her expenditures such that the marginalor her expenditures such that the marginalutility per dollar spent on each activity isutility per dollar spent on each activity isequal for all activitiesequal for all activities..

vv MUMUxx/P/Px x = MU = MUAOGAOG/P/PAOGAOG

uu For activities not undertaken, or goods notFor activities not undertaken, or goods notbought, the MU/P ratio is less than the ratiobought, the MU/P ratio is less than the ratiofor those activities undertaken.for those activities undertaken.

uu This rule is a necessary condition derivedThis rule is a necessary condition derivedfrom applying calculus to maximizationfrom applying calculus to maximizationproblems. It also follows from common senseproblems. It also follows from common senseas we will see.as we will see.

Consider Fran. She is trying to determine theConsider Fran. She is trying to determine theutility maximizing combination of trips to autility maximizing combination of trips to ablues club and to a coffee house to take perblues club and to a coffee house to take perweek.week.

Club Total Marginal CHouse Total MarginalClub Total Marginal CHouse Total MarginalTrips Utility Utility Trips Utility UtilityTrips Utility Utility Trips Utility Utility

1 12 12 1 1 12 12 1 20 20 20 20 2 22 10 2 2 22 10 2 36 16 36 16 3 31 9 3 3 31 9 3 50 14 50 14 4 39 8 4 4 39 8 4 62 12 62 12 5 45 6 5 72 10 5 45 6 5 72 10 6 49 4 6 80 8 6 49 4 6 80 8

If club trips cost $3.00 and trips to the coffeehouse cost $6.00, what will she buy with a $24budget?

Club Marginal MU/P CHouse Marginal MU/PTrips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7

2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3

4 8 2.7 4 12 2.0

5 6 2.0 5 10 1.7

6 4 1.3 6 8 1.3

First let’s look at Fran’sFirst let’s look at Fran’sWeekly Budget ConstraintWeekly Budget Constraint

Blues Trips

Coffee House Trips

8

4

She may select any combinationwithin the triangle formed bythe origin and the budget line, B

B

Note: The negative of the slope of the budgetconstraint is the ratio of relative prices

The Common Sense of MaximizingThe Common Sense of MaximizingUtilityUtility

Blues Trips

Coffee House Trips

8

4

B

Club Marginal MU/P CHouse Marginal MU/PTrips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7

2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3

4 8 2.7 4 12 2.0

5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.34

2

6

1

(6, 1) is on the budget line, butMU/P are not equal MU/P = 1.3for the blues < 3.7 for the coffee

You get more for your $ at thecoffee house

Now Apply the MU/P RuleNow Apply the MU/P Rule

Blues Trips

Coffee House Trips

8

4

B

Club Marginal MU/P CHouse Marginal MU/P

Trips Utility Trips Utility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

4

2

Club Marginal MU/P CHouse MarginalMU/P Trips Utility TripsUtility

1 12 4.0 (=12/3) 1 20 3.7 2 10 3.3 2 16 2.7 3 9 3.0 3 14 2.3 4 8 2.7 4 12 2.0 5 6 2.0 5 10 1.7 6 4 1.3 6 8 1.3

Utility Maximization RequiresUtility Maximization RequiresEqual MU/P Ratios and Being onEqual MU/P Ratios and Being onthe Budget Linethe Budget Line

Blues Trips

Coffee House Trips

8

B

4

2 4

MU/P =, but (6,6) is outside budget

Something To Think AboutSomething To Think Aboutuu To make life simpler, weTo make life simpler, we

compartmentalize problems such ascompartmentalize problems such asconsumer choiceconsumer choice

uu Fran has allocated so much of her budgetFran has allocated so much of her budgetto having fun, to clothing, etc. $24 in thisto having fun, to clothing, etc. $24 in thisexampleexample

uu We are looking at her choice problemWe are looking at her choice problemwithin the compartment ofwithin the compartment ofentertainment-hearing the blues, andentertainment-hearing the blues, andenjoying people/conversation at theenjoying people/conversation at thecoffee housecoffee house

Something Else to ThinkSomething Else to ThinkAboutAboutuu Visits to the Blues Club and the CoffeeVisits to the Blues Club and the Coffee

House has well defined costs--House has well defined costs--estimated by a “Price”estimated by a “Price”

uu Often we want things not available for aOften we want things not available for a$ price$ price

uu When this is the case, we estimate theWhen this is the case, we estimate the“cost” subjectively“cost” subjectively

uu Economists estimate these costEconomists estimate these costobjectively through statistical methodsobjectively through statistical methods

More Common Sense of theMore Common Sense of theMU/P RuleMU/P Ruleuu If MU/P for X = 10 and MU/P for Y = 5,If MU/P for X = 10 and MU/P for Y = 5,

you are getting more pleasure per dollaryou are getting more pleasure per dollarbuying Xbuying X

uu As you reallocate spending from Y to XAs you reallocate spending from Y to X(moving on your budget constrain), the(moving on your budget constrain), theMUMUXX falls and the MU falls and the MUYY increases. This increases. Thisfollows from the law of diminishing MUfollows from the law of diminishing MU

uu You continue to reallocate until the ratiosYou continue to reallocate until the ratiosare equalare equal

The Law of Demand and theThe Law of Demand and theMU/P RuleMU/P Ruleuu The rational for equating MU/P ratios toThe rational for equating MU/P ratios to

maximize utility implies the law ofmaximize utility implies the law ofdemanddemand

uu MUMUXX/P/PX X = MU= MUYY/P/PYY now suppose P now suppose PXXfallsfalls

uu MUMUXX/P/PX X > MU> MUYY/P/PY Y and you will buy and you will buymore Xmore X

uu So the Law of Demand is valid if theSo the Law of Demand is valid if theLaw of Diminishing MU is validLaw of Diminishing MU is valid

uu Can you think of Can you think of anyany exceptions? exceptions?

We need to wrestle with oneWe need to wrestle with onemore concept to discover themore concept to discover themeaning of Valuemeaning of Value

Consumer SurplusConsumer Surplusgo on to Part 2go on to Part 2

The EndThe EndPart 1