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Demand

Summary and Introduction to Demand

In microeconomics, demand refers to the buying behavior of a household. What does this mean?
Basically, micro economists want to try to explain three things:

1. Why people buy what they buy


2. How much they're willing to pay
3. How much they want to buy

Instead of looking at all consumers in the world, however, they try and model how smaller units
function: instead of asking, "How does the American market function?" they ask, "What will one
household do?" Each household, or small-scale decision-making unit, is affected by different
factors when making choices about what to buy and how much to buy. For instance, if one
household lives in Florida and another lives in Michigan, they might have different preferences
for clothing, since the climates are so different. Consumer preferences weigh heavily in a
household's buying decisions. Another factor that affects such decisions is income: a millionaire
and an average citizen will have very different purchasing choices, since they have different
budgets to work on. All buyers will try to maximize their utility, that is, make themselves as
happy as possible, by spending what money they have in the best way possible. By considering
both their preferences and their budget, they ensure that they end up with the best combination of
goods possible. Because the household is such a small unit, no household has a significant
impact on the market, and so the actions of any single household are its best effort to react to the
market price and the goods available.

In this unit on demand, we will learn how to work with graphical and mathematical models for
demand, we will observe how changes in price or income can affect demand, we will see how
consumers make choices under uncertainty, and we will apply that knowledge to calculate the
optimal purchases an individual consumer can make, given their income and the prices of goods.

Terms

Aggregate Demand - The combined demand of all buyers in a market.

Budget Constraint - The outermost boundary of possible purchase combinations that a person
can make, given how much money they have and the price of the goods in consideration.

Buyer - Someone who purchases goods and services from a seller for money.

Competition - In a market economy, competition occurs between large numbers of buyers and
sellers who vie for the opportunity to buy or sell goods and services. The competition among
buyers means that prices will never fall very low, and the competition among sellers means that
prices will never rise very high. This is only true if there are so many buyers and sellers that no
one individual has a significant impact on the market's equilibrium.
Complementary Good - A good is called a complementary good if the demand for the good
increases with demand for another good. One extreme example: right shoes are complementary
goods for left shoes.

Demand - Demand refers to the amount of goods and services that buyers are willing to
purchase. Typically, demand decreases with increases in price, this trend can be graphically
represented with a demand curve. Demand can be affected by changes in income, changes in
price, and changes in relative price.

Demand Curve - A demand curve is the graphical representation of the relationship between
quantities of goods and services that buyers are willing to purchase and the price of those goods
and services. Example:

A Sample Demand Curve

Diminishing Returns - Concept that the marginal utility derived from acquiring successive
identical goods decreases with increasing quantities of goods.

Economics - Economics is the study of the production and distribution of scarce resources, and
goods and services.

Equilibrium Price - The price of a good or service at which quantity supplied is equal to
quantity demanded. Also called the market-clearing price.

Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because
supply is equal to demand at this point, there is no surplus or shortage.

Expected Value (EV) - How much a buyer thinks that a good or investment will be worth after
a time lapse, based on the probabilities of different possible outcomes. Usually refers to stocks
and other uncertain investments.

Giffen Good - Theoretical case in which an increase in the price of a good causes an increase in
quantity demanded.

Firm - Unit of sellers in microeconomics. Because it is seen as one selling unit in


microeconomics, a firm will make coordinated efforts to maximize its profit through sales of its
goods and services. The combined actions and preferences of all firms in a market will determine
the appearance and behavior of the supply curve.

Goods and Services - Products or work that are bought and sold. In a market economy,
competition among buyers and sellers sets the market equilibrium, determining the price and the
quantity sold.
Horizontal addition - The process of adding together all quantities demanded at each price
level to find aggregate demand

Household - Unit of buyers in microeconomics. Because it is seen as one buying unit in


microeconomics, a household will make coordinated efforts to maximize its utility through its
choices of goods and services. The combined actions and preferences of all households in a
market will determine the appearance and behavior of the demand curve.

Income Effect - Income effect describes the effects of changes in prices on consumption.
According to the income effect, an increase in price causes a buyer to feel poorer, lowering the
quantity demanded, and vice versa. Although the buyer's actual income hasn't changed, the
change in price makes the buyer feel as if it has.

Indifference Curve - Graphical representation of different combinations of goods and services


that give a consumer equal utility or happiness.

Inferior Good - A good for which quantity demanded decreases with increases in income.

Marginal Utility - Additional utility derived from each additional unit of goods acquired.

Market - A large group of buyers and sellers who are buying and selling the same good or
service.

Market Economy - An economy in which the prices and distribution of goods and services are
determined by the interaction of large numbers of buyers and sellers who have no significant
individual impact on prices or quantities.

Market-clearing Price - The price of a good or service at which quantity supplied is equal to
quantity demanded. Also called the equilibrium price.

Microeconomics - Subfield of economics which studies how households and firms behave and
interact in the market.

Normal Good - A normal good is a good for which an increase in income causes an increase in
demand, and vice versa.

Optimization - To maximize utility by making the most effective use of available resources,
whether they be money, goods, or other factors.

Resource - A supply of capital that can be used in an economy. Because resources are scarce,
however, there is not enough to go around.

Risk - Refers to the amount of variation in possible payoffs. A very risky investment will have
wide variation in possible payoffs, but might have a higher expected value; a less risky
investment will have a more predictable payoff, but a lower expected value.
Risk-averse - Refers to a buyer who is unwilling to invest in an investment with wide variation
in possible payoffs. Someone who is risk-averse might even refuse to invest in something with a
positive expected value if the variation in possible outcomes is too great.

Risk-loving - Refers to a buyer who is willing to invest in an investment with wide variation in
possible payoffs, in the hopes of getting a large return. In extreme cases, a risk lover might even
invest in something with a negative expected value.

Risk-neutral - Refers to a buyer who does not care about variation in possible payoffs. A risk-
neutral buyer will invest in any investment with a positive expected return, regardless of how
risky it is.

Scarcity - Goods, services, or resources are scarce if there is not enough for everyone to have
as much as they would like.

Seller - Someone who sells goods and services to a buyer for money.

Substitute Good - Refers to a good which is to some extent interchangeable with another good,
meaning that when the price of one good increases, demand for the other good increases.

Substitution Effect - Describes the effects of changes in relative prices on consumption.


According to the substitution effect, an increase in price of one good causes a buyer to buy more
of the other good, since the first good has become relatively expensive, and vice versa. The
buyer substitutes consumption of the second good for consumption of the first.

Supply - Supply refers to the amount of goods and services that sellers are willing to sell.
Typically, supply increases with increases in price, this trend can be graphically represented with
a supply curve.

Utility - An approximate measure for levels of "happiness."

Wage - Price per unit of time when the good being sold is some form of labor or work (as
opposed to a physical product).

Two Approaches to Demand

The Graphical Approach


Economists graphically represent the relationship between product price and quantity demanded
with a demand curve. Typically, demand curves are downwards sloping, because as price
increases, buyers are less likely to be willing or able to purchase whatever is being sold. Each
individual buyer can have their own demand curve, showing how many products they are willing
to purchase at any given price, as shown below. This graph shows what Jim's demand curve for
graham crackers might be:
Jim's Demand Curve for Graham Crackers
To find out how many boxes of graham crackers Jim will buy for a given price, extend a
perpendicular line from the price on the y-axis to his demand curve. At the point of intersection,
extend a line from the demand curve to the x-axis (perpendicular to the x-axis). Where it
intersects the x-axis (quantity) is how many boxes of graham crackers Jim will buy. For instance,
in the graph above, Jim will buy 3 boxes when the price is $2 a box.

Aggregate Demand and Horizontal Addition


Typically, economists don't look at individual demand curves, which can vary from person to
person. Instead, they look at aggregate demand, the combined quantities demanded of all
potential buyers. To do this, add the quantities which buyers are willing to buy at different
prices. For instance, if Jim and Marvin are the only two buyers in the market for graham
crackers, we would add how many they are willing to buy at price p=1 and record that as
aggregate demand for p=1. Then we would add how many they are willing to buy at price p=2
and record that as aggregate demand for p=2, and so on. This results in the following graph of
aggregate demand for graham crackers:

Jim and Marvin's Demand Curves for Graham Crackers

Aggregate Demand Curve for Graham Crackers


This method is called horizontal addition because you look at a price level, and add the separate
quantities demanded across that price level, giving you total quantity demanded for that price.

There are many factors that can affect demand quantity, including income, prices, and
preferences. Let's look at one good to see how this works. How much are you willing to pay for a
cold soda? If you recently got a raise at your job, you might not mind buying a pricier soda, even
if you don't need it. Your friend who has less money, however, might pick a generic brand, or
they might stick with tap water. Below are possible demand curves for you (with your big raise)
and your friend (without your big raise). Note that you are willing to buy more soda than your
friend is:

2 Demand Curves for Soda


What if soda cost a dollar yesterday and costs two dollars today? That might make you think
twice about getting the same soda you drank yesterday. Likewise, if it cost two dollars yesterday
and a dollar today, you might be more willing to buy the soda than usual. We can see this on the
graph on a single demand curve. When the price is a dollar, the quantity demanded is higher than
when the price is two dollars. What this means in the real world is that if two companies charge
different prices for the same good, the company that charges a lower price will get more
customers. (Exceptions to this general rule may occur when there is a real or perceived
difference in quality of the goods being sold).

Changes in Demand with Changes in Price


We have been looking at how changes in price can affect buyers' decisions: when price increases,
demand decreases, and vice versa. However we have been assuming that when the price changes,
all else is staying the same; this restriction allows us to use the same demand curve, with changes
in demand being represented by movements up and down the same curve. This model of a buyer
moving up and down one demand curve is correct if the only thing that is changing is the price of
the good. If preferences or income change, however, the demand curve can actually shift.

For example, let's say that Conan's initial demand curve for concert tickets looks like curve 1. If
Conan gets a new job, with a permanently higher income, however, his demand curve will shift
outwards, to curve 2. Why is this? Conan realizes that he has more money, and that, as long as he
doesn't lose his new job, he will always have more money. That means that he can buy more of
what he likes, and he will have a higher demand curve for all normal goods.
Shifts in Demand
Note that for any price level, Conan's demand is now higher than it was before the demand shift.
This can also occur with a change in buyer preferences. If Conan suddenly decides that he wants
to collect jazz CDs, and he now likes jazz CDs much more than he did before, his demand curve
will shift outwards, reflecting his new appreciation of jazz, and his willingness to pay more for
the same CDs, since they have become more valuable in his eyes. Shifts in demand curves are
caused by changes in income (which make the goods seem more or less expensive) or changes in
preferences (which make the goods seem more or less valuable).

The Algebraic Approach


It is also possible to model demand using equations, known as demand equations or demand
functions. While these equations can be very complex, for now we will use simple algebraic
equations. We have been showing demand as straight, downward-sloping lines, which can easily
be translated into mathematical equations, and vice versa. Just as the graphs provide a visual
guide to consumer behavior, demand functions provide a numerical guide to consumer behavior.
For example, if Sean's demand curve for T-shirts looks like this:

Figure 1.7: Sean's Demand Curve for T-Shirts


The corresponding equation that describes Sean's demand for T-shirts is simply the equation for
the line on the graph, or:
Q = 25 - 2P
If we want to see how much Sean will buy if the price is 10, we plug 10 in for P and solve for Q.
In this case, [25 - 2(10)] = 5 T-shirts. When we want to find aggregate demand using the
algebraic approach instead of the graphical approach, we just add the demand equations together.
So, if we're adding Sean's demand for T-shirts to Noah's demand for T-shirts, it looks like this:

Figure 1.8: Aggregate Demand


If price for T-shirts is still equal to 10, we find out that together, Sean and Noah will buy

[65 - 5(10)] = 15 T-shirts.


One caveat in this method is that you can only add the equations together when both will result
in positive demand. For example, if the price of a T-shirt is $13, Sean would supposedly want to
buy [25 - 2(13)] = -1 T-shirts. Obviously that is impossible, and Sean will buy 0 T-shirts. But
because Sean's demand equation would yield the answer –1, adding the demand equations
together would result in a wrong answer. When using this method, always check to make sure
that there will be no negative demand for the given price before adding equations together. To
find how many T-shirts Sean and Noah would buy in this case, you would only look at Noah's
demand,
[40 - 3(13)] = 1 T-shirt.

Practice Problems
Problem 1.1: Nathan and Joe are shopping for video games. Nathan's demand function for video
games is Q = 30 - 3P, and Joe's demand function is Q = 48 - 4P. What will their combined
demand be if the price is $5? $11? [Solution]
Problem 1.2: Michelle is shopping for shirts. She chooses one, then notices that the shirts are on
sale, and gets another two shirts. How can you explain this with a graph? [Solution]
Problem 1.3: Jenn's parents increase her allowance, so she spends more money on candy every
week. How can you explain this with a graph? [Solution]
Problem 1.4: Kris and Tim's demand curves for playing cards look like this:

Tim and Kris's Demand curves for Playing Cards


Who wants more when the price is $3 a pack? $4 a pack? What is their combined demand at $4 a
pack? [Solution]
Problem 1.5: Emily decides to set aside $200 from her paycheck every month. How will this
affect her demand curve? (You don't have to use specific numbers, just explain) [Solution]

Income and Substitution Effects


Income and Substitution Effects
Changes in price can affect buyers' purchasing decisions; this effect is called the income effect.
Increases in price, while they don't affect the amount of your paycheck, make you feel poorer
than you were before, and so you buy less. Decreases in price make you feel richer, and so you
may feel like buying more.

What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and
hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might
be more inclined to buy a hot dog. This tendency to change your purchase based on changes in
relative price is called the substitution effect. When the price of hamburgers goes up, it makes
hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy
fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger
price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution
effect.

The income effect also affects buying decisions when there are two (or more) goods. When the
price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to
buy fewer of both hamburgers and hot dogs.

If you look at the combined results of the income effect and the substitution effect, the total
effect is a little unclear. According to the income effect, an increase in the price of hamburgers
decreases consumption of both hamburgers and hot dogs. According to the substitution effect,
however, hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear
what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot
be sure what happens to hot dog consumption, since there is both an increase (substitution effect)
and a decrease (income effect).

Table of Income and Substitution Effects


While we cannot be absolutely certain about the net result, in general, the substitution effect is
stronger than the income effect. That is, when the price of hamburgers goes up, you will most
likely eat fewer hamburgers and more hot dogs, since the change in relative prices (substitution
effect) affects you more than the perceived change in your income (income effect).

Another factor influencing demand is one which marketers and advertisers are always trying to
understand and target: buyers' preferences. What do people like? When and how do they like it?
Still looking at soda, it makes sense that people drink more soda when it's hot, or when they're
eating a meal, or when they've been exercising. In these cases, buyers' preferences have changed:
they want the soda more, and are therefore willing to pay more for the same good. Likewise, if
it's snowing, fewer people will crave a cold soda, and the price they are willing to pay for a cold
soda is lower, although they may be willing to pay a little extra money for a hot coffee.

Normal, Inferior, and Giffen Goods


Are all goods the same? Is more always better? Up to this point, we have been assuming that
when we have more money, or feel like we have more money, we will tend to buy more goods. It
makes sense: the more money we have, the more we buy. If we have less money, or if the price
goes up, however, we tend to buy less. Because this is usually the case, we call such goods
normal goods. If you buy more of a good when you have more money, that good is a normal
good. If the price of a normal good increases, you buy less.

There are some exceptions, however: not all goods are normal goods. For instance, if an increase
in your income causes you to buy less of a good, that good is called an inferior good. For
instance, "poor college students" often satisfy themselves with generic soda and cheap ramen.
When they get jobs and a steady income, however, they might forego the cheap soda and ramen
in favor of Coke and pasta. In this example, the generic soda and cheap ramen are inferior goods.

Income and substitution effects change demand differently with different types of goods. For
instance, we have been looking at income and substitution effects when a buyer is faced with a
choice between two normal goods. An increase in the price of good A will cause a decrease in
consumption of A, and an increase in consumption of good B (assuming that the substitution
effect is stronger than the income effect). If good A is a normal good, and good B is inferior,
however, the results will be different.

Why is this true? Consider the case where the price of good A goes up.

Income and Substitution Effects with Normal and Inferior Goods


The substitution effect makes B relatively cheaper, so consumption of B will increase, and
consumption of A will decrease. The income effect makes the buyer feel poorer, and so
consumption of A will decrease, but consumption of B will increase. Remember that
consumption of an inferior good varies inversely with income: when you are rich, you buy less,
when you are poor, you buy more.

If the A is still normal and B is still inferior, and the price of A falls, then the substitution effect
will cause higher consumption of A and lower consumption of B, and the income effect will
cause higher consumption of A and lower consumption of B. Because the buyer now feels richer,
they are less inclined to buy the inferior good.

Income and Substitution Effects with Normal and Inferior Goods


Another exception is the case where an increase in price causes an increase in demand. This
results in an upward-sloping demand curve, and the good is called a Giffen good. Giffen goods
are theoretically possible, but very improbable, since it is unlikely that an increase in price
causes increase in demand. One possible justification for a Giffen good is that people associate
higher prices with status, luxury, and quality, so that a higher price might increase the perceived
value of a good. In reality, however, this effect is outweighed by the overwhelming tendency to
prefer lower prices: even if a few people prefer the added cachet of a high-priced luxury good,
the general public will prefer lower prices. Another possible case that could cause a Giffen good
is the case in which a good is inferior and the income effect outweighs the substitution effect. To
illustrate, assume that ACME Cola is an inferior good. When it's price increases, the income
effect makes Calvin feel poorer. If the income effect is very strong, and the substitution effect is
very weak, then Calvin will buy more ACME Cola, because the consumption of inferior goods
increases with decreases in income. This, too, is unlikely, however, because the substitution
effect is almost always stronger than the income effect.

Demand Curve for a Giffen Good

Practice Problems
Problem 2.1: Which of the following are complementary goods, and which are substitute goods?

Right and left shoes?


Sweaters and sweatshirts?
Hot dogs and ketchup?
Nickels and dimes?
Ice cream and sorbet?
Chips and salsa? [Solution]
Problem 2.2: If Marianne is grocery shopping for cheese and notices that there is a sale on Swiss
cheese, how will that affect her demand for Swiss cheese and Emmenthal cheese? [Solution]
Problem 2.3: Consider the case where Katie gets a raise. How will that affect her consumption
of Spam (an inferior good) and steak (a normal good)? What if her income drops? What will
happen to her Spam and steak consumption? [Solution]
Problem 2.4: One of Ruby's favorite cereals, Special K, is on sale at 20% off. How will that
affect her buying decision between Special K and Cheerios? What if both are on sale at 20% off?
[Solution]
Problem 2.5: What is the difference between a Giffen good and a normal good? [Solution]

Utility
Utility and Indifference Curves
We know how to represent changes in demand as price or income changes on a graph, but how
can we show preferences? What makes buyers happy and how can we measure that happiness?
Economists use the term utility when referring to the level of happiness or satisfaction that
someone experiences from buying (or selling) goods and services: the more utility, the happier
the person. Utility is typically represented on a graph in an indifference curve. An indifference
curve represents all of the different combinations of two goods that generate the same level of
utility. What this means is that each point on an indifference curve represents a combination of
goods. All points on one indifference curve give the person the exact same amount of happiness.
For instance, if you give Jim a choice between points A and B on this indifference curve, he
won't really mind either way, he is indifferent. One shirt and two hats makes him just as happy as
two shirts and one hat, which is why both points are on the same indifference curve.

One of Jim's Indifference Curves for Shirts and Hats


In general, indifference curves bow in towards the origin, rather than being straight lines or
outward-bulging curves. The reason for this is that most people do not like extremes: they would
rather have a some shirts and some hats than many hats and no shirts. This changing preference
results in the traditional inward-curving indifference curves, and illustrates the effects of
diminishing returns. In this example, diminishing returns simply means that the first hat Jim gets
makes him happier than the second hat, which makes him happier than the third, and so on. His
marginal utility--the extra utility he gets with each hat--decreases with the number of hats he
gets. After a while, he has had enough of hats, the extra ones don't make him much happier, and
he'd rather get a shirt, and might even trade several hats for one shirt. Generally, at the extremes,
people are willing to give up many hats to get a few shirts; as the numbers even out, this
swapping ratio decreases, and then when they start moving to the other extreme, they want a lot
of shirts in exchange for any hats they might give up.

Another example that illustrates the principle of diminishing returns would be the case in which
you give Thom a choice between gold and steak. We all know that a bar of gold is worth more
than a steak, so only a fool would choose the steak over the gold, right? Thom knows this. If you
ask Thom to choose between a bar of gold and a steak, he will probably choose the gold, and be
very excited to have a bar of gold. The marginal utility of that first bar of gold is quite high. An
hour later, he will choose another bar of gold, and he will still be happy to get another bar of
gold; the marginal utility he gets from the second bar of gold might not be quite as high as the
marginal utility from the first bar, but it's still higher than the marginal utility he would get from
a steak. This will continue, bar after bar, with the added utility of each bar of gold being a little
lower than the last. Eventually, Thom will start to get hungry, and if he gets hungry enough, then
he will choose the steak over the gold, as the marginal utility from the steak will be higher than
the marginal utility from a bar of gold. Thom still knows the relative values of gold and steak,
and he knows that he is choosing something that is worth less, but in his situation, he has so
much gold that more gold makes very little difference, but a steak can make a large difference, as
he is very hungry.

Different indifference curves represent different levels of utility, and in general, more is better:
the more goods you have, the happier you are. On the graph, we see this preference for more as
an indifference curve that is further away from the origin. Thus, because curve 2 is further out
than curve 1, and represents a higher level of utility, any point on curve 2 will be preferable to
any point on curve 1, and any point on curve 3 will be preferable to any point on curves 1 or 2.

Indifference Curves
A few more important observations about one person's indifference curves: they can never cross.
Why is this true? Think about it this way: if curve 2 is supposed to make you happier than curve
1, but curve two crosses curve 1, then that means that at the point of intersection, you are
experiencing two different levels of utility, that is, you are both happy and happier at the same
time, which makes no sense. Thus, indifference curves never intersect, but move further away
from the origin with increased levels of utility.

A Correct Set of Indifference Curves


An Incorrect Set of Indifference Curves
The indifference curves we have been considering are for normal goods. How can we tell?
Because more of either good increases utility. Starting on curve 1 and moving outwards
(increasing the number of hats) or upwards (increasing the number of shirts) lands us on curve 2,
representing a higher level of utility. Using different types of goods changes what indifference
curves look like.

For instance, if one good is a normal good, such as CDs, and the other good is an undesirable
good, such as Spam, the indifference curves will look like this, with the second indifference
curve being better than the first:

Utility Curves for Normal and Undesirable Goods


As you can see, an increase in number of CDs causes an increase in utility, since we end up on a
better indifference curve, but an increase in the amount of Spam results in a decrease in utility.

What if the consumer doesn't care about one of the goods, meaning that getting more or less of
that good doesn't make them happier or unhappier? For instance, replace the Spam with expired
baseball tickets. Jim likes getting CDs, but really doesn't care how many expired baseball tickets
he gets. This makes his indifference curves look like this:
Indifference Curves for Normal and Neutral Goods
Note that increasing or decreasing the number of baseball tickets makes no difference in his
indifference curve; only changing the number of CDs moves him to a different indifference
curve.

Another instance in which indifference curves behave strangely is in the case of complementary
goods. Demand for complementary goods is directly related. In other words, buying one good
increases the probability you'll buy the other good, those two goods are complementary. Mittens
are an extreme example of complementary goods: if you buy a right mitten, it is almost a sure bet
that you'll buy a left mitten. This also means that having extra stray mittens isn't likely to
increase your utility. There is virtually no difference in your happiness whether you have one
right mitten and one left mitten, or two right mittens and one left mitten. This shows up in the
following indifference curves (note that only a simultaneous increase of right and left mittens
will result in increased utility).

Indifference Curves for Complementary Goods: Mittens


What if the two goods being evaluated are pretty much the same? Such goods are called
substitute goods: the buyer considers them to be interchangeable. One example of perfect
substitutes (though some might argue otherwise) could be Coke and Pepsi. If you consider them
to be the same thing, then you don't mind which one you get. More is still better, but you don't
care what combination of the two you get, which means that when you have a lot of Pepsi, you
would not be willing to trade three cans of Pepsi for one can of Coke, eliminating the inward
bend of the indifference curves. This results in indifference curves like this:
Indifference Curves for Substitute Goods: Cola

Utility Optimization

While it is impossible to know exactly what goes on inside a buyer's head while they are making
a decision, we can assume that a normal person will choose whichever combination will make
them as happy as possible, given their choices and their budget. On the graph, this means that
they will choose whichever combination lands them on the highest indifference curve possible.
We can see this optimization if we draw in the consumer's budget constraint on the same graph
as the consumer's indifference curves.

To draw a budget constraint, a line that shows the maximum amount of goods a buyer can
purchase with their available funds, you need to know two things: 1) how much money they
have, and 2) the prices of the two goods being considered. Once you have both pieces of
information, it is simply a matter of finding out the maximum amount of the first good you can
buy, without buying any of the second, then finding the maximum amount of the second good
you can buy, without buying any of the first. Mark these points on the graph and connect them.
To illustrate, suppose Tina has $100. She is deciding how many bottles of wine and how many
wine glasses she wants to buy. If wine costs $20 a bottle and glasses cost $5 each, then the most
wine she can buy is ($100/$20)=5 bottles. Likewise, she can buy at most ($100/$5)=20 wine
glasses. Her budget constraint would look like the darker line, while the filled area includes all of
her possible buying decisions, given the amount of money she has. Anything not included in the
colored area is out of her budget:
Tina's Budget Constraint
If we know her indifference curves, we can draw her budget constraint in with them on the same
graph. After that, it is simply a matter of finding the outermost indifference curve that is tangent
to (just barely touches) her budget constraint, and use this tangent point as her optimal
combination of wine and glasses. In this case, it is the second indifference curve that optimizes
her utility given her budget.

Optimizing Tina's Purchasing Decision


It looks like Tina will buy about 12 wine glasses and 2 bottles of wine. Even though the optimal
amount is a little more than 2 bottles, she has to buy either 2 bottles or 3 bottles, and 2 is all she
can afford. (When doing such problems, never round up, since that will land you outside of the
budget constraints).

Why does it have to be the indifference curve that is tangent to her budget constraint? If it were
an indifference curve that crosses her budget constraint, such as the first indifference curve, then
we can see that the two points of intersection don't make her as happy as the single tangent point
in the previous graph. By picking the outermost curve that still touches her budget constraint, we
have maximized her utility. We can't pick a curve any further out, such as the third indifference
curve, since she can't afford to buy more than $100 worth of wine and glasses.

Obviously, budget constraints change with changes in income or price. For instance, if Tina now
has $125 instead of $100, her new budget constraint will be a parallel shift out from her original
budget constraint. The yellow shaded region represents the increase in possible purchases she
can make:
A Shift in Tina's Budget Constraint
On the other hand, if Tina still has only $100, but the price of wine changes from $20 a bottle to
$10 a bottle, her budget constraint will pivot to reflect this change:

A Pivot in Tina's Budget Constraint

Practice Problems

Problem 3.1: Kate has $12. Pretzels cost $2 a bag, and soda costs $3 a bottle. Draw her budget
constraint. If soda goes on sale for $2 a bottle, what does her new budget constraint look like?
[Solution]
Problem 3.2: Jeannette has $300. DVD's cost $30 and CD's cost $15. Draw her budget
constraint for DVD's and CD's. Draw her budget constraint if she has $360. [Solution]
Problem 3.3: J.P.'s indifference curves for beer and movies look like this:
J.P.'s Indifference Curves

Beer costs $4 and movies cost $6. If J.P. has $24, how much of each will he buy? [Solution]
Problem 3.4: Draw the indifference curves for cashmere sweaters and moth-eaten sweaters
(assuming that moth-eaten sweaters are undesirable and cashmere sweaters are desirable).
[Solution]
Problem 3.5: Lawrence is looking for tables and chairs. His indifference curves look like this:

Lawrence's Indifference Curves

He has $500 to spend, how many tables and chairs will he buy if chairs cost $50 and tables cost
$100? [Solution]

Consumer Behavior in Uncertain Situations

Choice Based on Expected Value

In some cases, buyers must make a purchase decision without knowing exactly what they're
getting for their money. Deciding whether or not to buy a good without knowing exactly what
the good is worth involves some degree of risk, as there is variation in the possible outcome. To
make these decisions, buyers have to evaluate, to their best ability, how much the goods are
really worth, and then decide how much they are willing to pay for the goods. For example, if
Jevan is interested in buying stock in a new startup, he can't be sure what will happen to the
value of his stock as time passes. The company could be a huge success, making his stock very
valuable, it could be a moderate success, making his stock somewhat valuable, or it could be a
failure, making his stock worthless. Before he decides to buy any stock, Jevan has to decide what
is the most likely outcome, and what his stock is going to be worth: that is, based on the
probability of different outcomes, Jevan has to assign the stock an expected value to compare
against the present price.

In order for Jevan to be able to calculate this expected value, he needs to account for all
possible outcomes, so that the total probability will be equal to 1: let's assume that huge success,
moderate success, and failure are the only possible outcomes, so the probability of at least one of
them occurring is equal to 1. If Jevan thinks that there is a 1 in 8 chance that the startup will be a
wild success, a 1 in 2 chance that it will be a moderate success, and a 3 in 8 chance that it will
fail, then he has accounted for all possible outcomes, since the combined probabilities are equal
to 1: (0.125 + 0.5 + 0.375) = 1

Next Jevan has to assign values to each outcome. In the event of huge success, Jevan thinks that
each share of stock will be worth $20. In the event of moderate success, each share will be worth
$5. In the event of failure, each share is worth $0. Combining all of Jevan's assumptions gives us
the following chart of his expectations:

Jevan's Expectations for the Startup Stock's Performance


To find out the expected value (EV) of the stock, multiply the probability of each event by the
value of each event, and sum the results:

EV = (0.125)(20) + (0.5)(5) + (0.375)(0)


EV = $5 a share

We find that Jevan expects the stock to be worth about $5, based on his assumptions about
company performance. What this means is that Jevan will not be willing to pay more than $5 a
share for this stock, since he believes it to be worth $5 a share. He will probably be willing to
buy stock if the price is lower than $5, depending on how much he enjoys taking risks.

How would we explain it if the price is lower than $5, but Jevan decides not to buy any stock?
We know that he believes the stock to be worth $5, so we would expect him to buy stock if it is
priced lower than $5 a share. This can be explained by Jevan's openness to taking risks. Because
the future price of the stock is uncertain, and Jevan's estimate is only an estimate, if Jevan doesn't
like taking risks, that is, if he is risk-averse, then he may choose not to buy any stock, even if the
expected returns are positive; he is not willing to invest in a "good" investment because he is still
afraid of the possibility that he might lose money. Someone who is risk-averse will choose
investments with little variation in possible outcomes, and a high degree of predictability.

On the other hand, if the price of the stock is over $5, and Jevan still decides he wants to buy
stock, even though he believes it to be worth only $5 a share, then it may mean that he is risk-
loving; he is willing to enter into an expected loss on the off chance that the company will make
it big. This would be an extreme case; not all risk lovers will invest in stocks with negative
expected values. More commonly, risk lovers will make investments that have positive expected
values, but have very large variation in possible outcomes.

If Jevan is risk-neutral, then he will not buy stock with negative expected value, he will buy
stock with positive expected value, and stock with 0 expected value makes no difference to him
at all. Even if the risk is very high, if the expected returns are positive, he will make the
purchase. Even if the risk is very low, if the expected returns are negative, he will refuse to buy
stock.

This type of decision-making based on probable outcomes is used in many different


situations: buyers decide how much they are willing to pay for a used car based on the different
probabilities that it is in mint condition, that it needs minor repairs, or that it is a useless piece of
junk. Students decide how much to study based on their expected performance after different
amounts of studying. Art lovers base their decisions on the probabilities that the pieces they are
looking at are genuine or forged. In any case where the exact value of a good is unclear, buyers
must make their decisions based on probable outcomes and possible worth. After making an
estimate of expected value and assessing the risk involved, buyers can then attempt to maximize
their utility based on their individual preferences for goods.

Risk usually varies inversely with expected returns. That is, a high risk investment will often
yield a much higher potential payoff than a low risk investment. This difference in value can be
seen as a "reward" for buyers' willingness to take a higher risk. The "penalty" for taking a higher
risk is the possibility of losing a lot of money if the investment fails. We can see this discrepancy
in the high yields (and losses) in the stock market, which is relatively high risk, the moderate
yields of mutual funds, which are relatively moderate risk, and the low yields of government
bonds, which are relatively low risk. When a payoff is guaranteed, as with low risk investments,
the payoff is usually small, and when a payoff is uncertain, as with high risk investments, the
payoff is usually higher.

Practice Problems

Problem 4.1: Company A and Company B are both selling stock at $1 a share. If risk-neutral
Kenny wants to buy stock in either Company A or Company B, and he thinks that the possible
future values for Company A's stock are $0, $1, $5, and $20, with respective probabilities of
20%, 50%, 20%, and 10%, and that the possible future values of B's stock are $0, $1, $10, and
$100, with respective probabilities of 50%, 30%, 15%, and 5%, which stock will he pick?
[Solution]
Problem 4.2: Which of the following are high risk investments, and which are low risk?

Gold
Stocks in new companies
IRA's
Savings bonds
Lottery tickets [Solution]
Problem 4.3: What is the expected value of a stock whose possible future values are $0, $1, $10,
and $60 with respective probabilities of 25%, 50%, 20%, and 5%? [Solution]
Problem 4.4: If the current price of a stock is $7 a share, will risk-neutral Andy buy any stock if
he believes that the possible future values are $0, $2, $5, $10, and $50, with respective
probabilities of 10%, 15%, 50%, 20%, and 5%? [Solution]
Problem 4.5: What is the maximum price that risk-neutral Tamara will be willing to pay for a
stock which she believes has possible future values of $0, $5, $10, and $200, with respective
probabilities of 50%, 25%, 24%, and 1%? [Solution]