Demand Analysis Chapter 4

The Basis for Consumer Demand

The ability of goods and services to satisfy consumer wants is the basis for consumer demand. Utility theory helps us understand the basis for demand since it explains the relationship between consumer satisfaction and the goods and services consumed.

Utility Functions

A mathematical representation of the relationship between total utility and the consumption of goods and services. Utility = f(Goods, Services) The utility function is shaped by the tastes and preferences of consumers, and the quantity and quality of available products.

Utility Functions

The utility derived from consumption is intangible. Consumers reveal their preferences through purchase decisions and provide tangible evidence of the utility they derive from various products.

Marginal Utility

Measures the added satisfaction derived from one-unit increase in consumption of a particular good or service, holding consumption of all other goods and services constant.

Total and Marginal Utility

Sandwiches per Meal, S 0 1 2 3 4 5 6 Total Utility, U 0 5 9 12 14 15 15 Marginal Utility, MUS = U/S 5 4 3 2 1 0 Maximum Acceptable Sandwich Price at 20 per MUS $1.00 0.80 0.60 0.40 0.20 0.00

Total and Marginal Utility

The marginal utility is diminishing as consumption of sandwiches is increasing. If each sandwich costs $1:

1st sandwich:

cost per unit of utility = 1/5 = 0.20

2nd sandwich:

cost per unit of utility = 1/4 = 0.25

Total and Marginal Utility

As a result of diminishing marginal utility, the cost of each marginal unit of satisfaction increases as we increase our consumption of sandwiches. Assume that the consumer has alternative consumption opportunities that would provide one additional unit of utility for 20. Then, the consumer will be willing to increase the consumption of sandwiches only if sandwich prices were to fall.

Total and Marginal Utility

If the required price/marginal utility trade-off for sandwiches is 20 per unit of satisfaction, then the consumer will pay $1 for a single sandwich. In order for the consumer to purchase one more sandwich, the second sandwich should cost only 80 (20 x 4 units of satisfaction). Similarly, in order for the consumer to purchase the third sandwich, the third sandwich should cost only 60 (20 x 3 units of satisfaction).

The Law of Diminishing Marginal Utility

As an individual increases consumption of a given product, the marginal utility gained from consumption eventually declines. This law gives rise to a downwardsloping demand curve for all goods and services.

The Demand Curve

1,2 1 0,8 0,6 0,4 0,2 0
0 1 2 3 4 5 6 7

Price ($)

Quantity of Sandwiches

Consumer Choice

Products are frequently consumed as part of a basket of goods and services. Within this basket, products can be substituted for each other. The substitution occurs at different degrees for different pairs of products.

Consumer Choice: Total and Marginal Utility

Quantity 1 2 3 4 5 6 7 8 9 10 Goods (Y) Marginal Utility Total Utility (MUY | X=4) 55 67 12 77 10 8 85 92 7 98 6 103 5 107 4 109 2 110 1 Services (X) Marginal Utility Total Utility (MUX | Y=1) 25 36 11 46 10 9 55 63 8 70 7 76 6 81 5 4 85 88 3

Consumer Choice: Indifference Curves

E.g. A consumer can choose to buy a basket with a high proportion of total expenditures devoted to services or vice versa. For this consumer, a large number of baskets can be created that provide the same level of utility to the consumer. An indifference curve represents all market baskets among which the consumer is indifferent about choosing.

Indifference Curves
10 9 8 7 6 5 4 3 2 1 0
) Y ( s d G f o y i t n a u Q

10

Quantityof Se rvice (X) s

U1 = 100 units U2 = 118 units

Indifference Curves

Indifference curves will never intersect with each other. Higher curves will represent higher levels of utility. The consumer will want to consume a basket on a relatively higher indifference curve in order to increase/maximize his/her utility.

Marginal Rate of Substitution

The slope of each indifference curve equals the change in goods (Y) divided by the change in services (X). Marginal rate of substitution is the slope relation that shows the change in the consumption of Y (goods) necessary to offset a given change in the consumption of X (services) if the consumers overall level of utility is to remain constant.
MRS = Y / X = slope of an indifference curve

Marginal Rate of Substitution

MRS is not constant along an indifference curve. From left to right, MRS usually declines as the amount of substitution increases. MRS declines because of the law of diminishing marginal utility.

Marginal Rate of Substitution

When we move from a left-hand-side point to a right-hand-side point on a given indifference curve: the loss in utility associated with a reduction in Y is equal to U = MUY x Y. the gain in utility associated with an increase in X is equal to U = MUX x X.

Marginal Rate of Substitution

Along an indifference curve, the utility level does not change. Therefore, the absolute value of the change in utility for reducing Y needs to be equal to the change in utility for increasing X. So, the following must be true: MUY x Y = (MUX x X ) The absolute value of the changes in utility must be the same and the signs must be opposite in order for TU to stay constant.

Marginal Rate of Substitution

When MUY x Y = (MUX x X ) is true, the following must also be true:

MU X Y = MU Y X
MRSXY = Slope of an indifference curve The slope of the indifference curve is determined by the ratio of the marginal utilities derived from each product.

Consumer Choice: Budget Lines

The second important determinant of the consumer choice is the existence of a budget constraint. A budget line represents all combinations of products that can be purchased for a fixed dollar/lira amount:

Consumer Choice: Budget Lines

Total Budget = Spending + Spending on Goods on Services = PY Y + PX X

The expression for the budget line becomes:

B PX Y= X PY PY

Budget Line
10 9 8 7 6 5 4 3 2 1 0 0 2 4 6 8 10 12 14 16 18 20

Budget = $1,000 U1 = 100 units

Budget = $1,500 U2 = 118 units

Budget = $2,000

Decrease in Price of Y
10 9 8 7 6 5 4 3 2 1 0 0 2 4 6 8 10 12 14 16 18 20

B udge t = $ 1 ,5 0 0 , P Y = $ 2 5 0 U 1 = 1 0 0 un it s U 2 = 1 1 8 un it s B udge t =$ 1 ,5 0 0 , P Y =$ 1 5 0 B udge t = $ 1 ,5 0 0 , P Y =$ 7 5

Effect of Price Changes

Consumer is affected in two ways: 1. Income Effect: With the same budget, a price decrease allows higher consumption (higher indifference curve) and a price increase causes lower consumption (lower indifference curve). Change in the quantity demanded as a result of a change in the consumers real income (real income changes as result of a change in the price level)

Effect of Price Changes

2. Substitution Effect: With the same budget, a price increase makes the product relatively more expensive and shifts the overall consumption away and more towards the cheaper product (movement along the indifference curve). Change in the quantity demanded that is the result of only a change in the relative prices of goods, given a constant real income.

Effect of Price Changes

3. Total Effect: Total effect is the sum of income and substitution effects.

Effect of Price Changes

Price of X decreases
Nominal income is the same. Same combination can be bought by spending less of the nominal income. Consumer has money left to purchase more of X or Y. Consumers real income has increased. Income effect is the change in the combination due to the new real income. Consumer can move to a higher indifference curve. Nominal income is the same. If the real income were kept at the original level, what is the combination that the consumer would buy? Substitution effect is the change in the combination due to the new price ratio, under the original real income. Consumer would choose another point on the same indifference curve.

Decrease in Price of Y
11 10 9 8 7 6 5 4 3 2 1 0 0 2 4 6 8 10 12 14 16 18 20

B udge t = $ 1 ,5 0 0 , P Y = $ 2 5 0 U 1 = 1 0 0 un it s U 2 = 1 1 8 un it s B udge t = $ 1 ,5 0 0 , P Y = $ 1 4 0

Optimal Consumption

Optimal consumption will occur when utility for the consumer is maximized. Utility is maximized when a consumer chooses a basket of products on the highest indifference curve possible, for a given budget expenditure.

Consumer Choice: Budget Constraint and Utility

The budget constraint will impose a limit on the level of utility a consumer can derive from consumption of the basket of products. The highest indifference curve a consumer can reach will be determined by the budget constraint.

Elasticity

Percentage relationship between two variables: elasticity = % change in A / % change in B Price elasticity shows the sensitivity of demand to changing prices:
price elasticity = % change Q / % change in P

Price Elasticity

Mathematically, % change in Q = Quantity / Initial Quantity and, % change in P = Price / Initial Price Therefore,

Q P % in Q = Q P % in P

Arc Elasticity

Measures the sensitivity of Q to changes in P over a range of price values:

Q2 Q1 P2 P1 Ep = (Q1 + Q2 )/2 (P1 + P2 )/2 Q2 Q1 P1 + P2 Ep = Q1 + Q2 P2 P1

Arc Elasticity

E.g. If the price of a product rises from $11 to $12, the quantity demanded falls from 7 to 6 units. The arc elasticity of demand over this price range is:
67 12 11 Ep = = 1.77 (6 + 7)/2 (11+ 12)/2

Arc Elasticity

We use averages in the denominators because: 1. If we had used the beginning values (Q=7, P=$11), Ep would equal to -1.57. 2. If the price decreases from $12 to $11, then Q increases from 6 to 7. If we use beginning values (Q=6, P=$12), this time Ep equals -2.0. 3. It looks like we have a different sensitivity depending on whether we have a price increase or a price decrease. Using averages avoids this ambiguity.

Point Elasticity

Measures the sensitivity of Q to changes in P when the change is very small:

dQ P1 Ep = x dP Q1
where dQ/dP is the derivative of Q with respect to P.

Point Elasticity

E.g. Q = 18 - P When Q = 6 and P = 12, Ep = -1 x (12/6) = -2 Note that when the demand curve is linear, (dQ/dP) is constant along the demand curve. However, Ep changes as Q and P values change.

Point Elasticity

E.g. Q = 100 - P2 When Q = 75 and P = 5, Ep = -2P x (5/75) = -50 / 75 = -0.67 E.g. Q = 100 / P1.7 When Q = 10 and P = 3.875, Ep = ? Rewrite the demand equation: log Q = log 100 - 1.7 log P

Elasticity Definitions

|Ep| > 1 relatively elastic demand (% in Q > % in P) 0 < |Ep| < 1 relatively inelastic demand (% in Q < % in P) |Ep| = 1 unitary elasticity (% in Q = % in P) |Ep| = perfect elasticity (% in Q >> % in P since % in P = 0) |Ep| = 0 perfect inelasticity (% in Q = 0)

Determinants of Elasticity

Ease of substitution Proportion of total expenditures Durability of product Possibility of postponing purchase Possibility of repair Used product market

Demand Elasticity and Revenue (TR = Q x P)

Price increase:

|Ep| > 1 (% decrease in Q > % increase in P) TR is decreasing. 0 < |Ep| < 1 (% decrease in Q < % increase in P) TR is increasing. |Ep| = 1 (% decrease in Q = % increase in P) TR does not change.

Demand Elasticity and Revenue (TR = Q x P)

Price decrease:

|Ep| > 1 (% increase in Q > % decrease in P) TR is increasing. 0 < |Ep| < 1 ( % increase in Q < % decrease in P) TR is decreasing. |Ep| = 1 (% increase in Q = % decrease in P) TR does not change.

Price 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Quantity 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Arc Elasticity -35.0 -11.0 -6.2 -4.1 -3.0 -2.3 -1.8 -1.4 -1.1 -0.9 -0.7 -0.6 -0.4 -0.3 -0.2 -0.2 -0.1 0

Revenue 0 17 32 45 56 65 72 77 80 81 80 77 72 65 56 45 32 17 0

20 18 16 14 12 10 8 6 4 2 0 0

Elastic

Unitary Inelastic

10

12

14

16

18

20

Demand Elasticity

80 60 40 20 0 0 2 4 6 8 10 12 14 16 18 20

Total Revenue

Demand and Marginal Revenue

P Elastic

Ep = -1 Inelastic

MR D

Demand and Revenue

Demand Curve: Total Revenue: Marginal Revenue:

P = a - bQ PxQ = aQ - bQ2 dTR/dQ = a - 2bQ

Note that the demand curve and the marginal revenue curve share the yintercept. Marginal revenue curve has twice the slope

Cross-Elasticity of Demand

Shows the impact on the quantity demanded of a particular product created by a price change in a related product (substitutes or complements):

QA PB Ex = QA PB

Ex > 0 for substitutes. Ex < 0 for complements.

Income Elasticity of Demand

Sensitivity of quantity demanded to changes in the consumers income:

Q Y EY = Q Y

EY > 1.0 for superior goods. 0 EY 1.0 for normal goods. EY < 0 for inferior goods.