2nd lecture-demand and consumer behavior

8/3/2019 2nd Lecture-Demand and Consumer Behavior

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Chapter 5:

Demand and ConsumerBehavior


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Utility Theory

Utility: Utility means want satisfying Power. A goodthat gives you Utility is one that has the power to satisfy

wants, or that gives you satisfaction.

Example: A Pen has writing ability.

Total Utility is the total satisfaction a person receives

from consuming a particular quantity of good.

Also, Total Utility is the summation of all individualutilities to be derived through the consumption of a

commodity.


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Marginal Utility

Marginal Utility is the additional utility

gained from consuming an additional unit

of some good.

Marginal Utility is the change in total utilitydue to a one-unit change in the quantity of a

good or service consumed.

Marginal utility =change in total utility

change in number of units consumed


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Relationship between Total Utility and Marginal

Utility

Observations:

Marginal utility falls as more is consumed

Marginal utility equals zero when total utility is at itsmaximum


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5

Relationship between Total and Marginal

Utility of Watching DVDs

Total utility is

maximized...

where marginal

utility equals zero.

Marginal

Utility(utilsperwee

k)

01 2 3 5 6 7

-4

-2

2

4

6

8

10

DVDs Watched per Week

4

DVDs Watched per Week

To

talUtility(utilsperw

eek)

0 1 2 3 4 5 6 7

2

4

6

8

10

12

14

16

18

20


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Relationship Between Total Utility and

Marginal Utility

1. With the rise in consumption of a product, total utility tends

to be rising but marginal utility tends to be falling.

2. Total Utility is the summation of all individual utilities to be

derived through the consumption of a commodity. Marginalutility is the additional utility to be derived through the

consumption of last unit of a product.

3. With the rise in consumption total utility tends to be

increasing but at a diminishing rate.

4. Total utility is maximum when marginal utility is zero. Total

utility tends to be falling when marginal utility is negative.


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Basic assumptions ofMarginal Utility

Analysis

Cardinal measurement of utility:- It is assumed thatutility can be measured and can be given definite quantitylike 1,2 or 3.This means that a person can express the

satisfaction derived from consumption of commodity inquantitative term.

Utilities are independent:-Marginal utility assumes thatutility of different commodities are independent to eachother.

Constant Marginal utility of money:-Another importantassumption is that the marginal utility of money remainsconstant.

Introspection:-The Marginal utility also assumes that from

ones experience ,it is possible to draw inference about


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Law of Diminishing Marginal Utility

The law of DiminishingM

arginalU

tilitystates that for a given time period, themarginal utility gained by consumingequal successive units of a good willdecline as the amount consumed increases.

The law of diminishing marginal utilityis based on the idea that if a good has avariety of uses but only one unit of the

good is available, then the consumer willuse the first unit to satisfy his or her mosturgent want.


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Diminishing marginal utility curve

Assumptions:

Goods are homogeneous. No time gap between the consumption of the different

units.

Consumers are rational.

Taste, Preferences Fashions remain unchanged.

Income of the consumer is constant.


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This can also be shown by graph

Units of commodity consumed

Units ofutility


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Law of Diminishing Marginal Utility

It is generally accepted rule of consumption that total utility tends to beincreasing and marginal utility tends to be gradually decreasing as withthe rise of consumption. Because with the rise in stock of anythingmarginal utility of a particular product gradually diminishes. Thereforethe relationship between rise in consumption of a product and gradual

fall in marginal utility of that product is represented by the law often wecalled the diminishing marginal utility.

For ex:- Suppose a person starts eating toast, the first toast gives himgreat pleasure. By the time he taking second he yield less satisfaction;the satisfaction of third is less than that of second and so on. theadditional satisfaction goes on decreasing with every successive toasttill it drops down to zero; and if the consumer forced to take more thesatisfaction may become zero.


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LIMITATIONS OF THE LAW

Suitable units:- It is assumed that the commodity is taken insuitable units.

Suitable time:-It is further assumed that the commodity is taken

within a certain time, otherwise law will not apply. No change in consumers tastes:-Another assumption is that

the character of the consumers does not change.

Normal persons:- The law of diminishing marginal utilityapplies to normal persons and not to eccentric or abnormal

persons like misers. Constant income:-it is also essential that the income remains

the same. Any change in income will falsify the law.

Rare collections:- In case of rare collections ,the law does not

hold good.

Fashion:- Further, fashion utility depends on fashion too.


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Indifference Curve

An Indifference curve is the locus of points indicating particularcombinations of goods or the baskets of two commodities from whichthe consumer derives the same level of utility or satisfaction.

The I.C. is the locus of successive indifferent points or combinationswhich yield equal level of satisfaction. This curve is also known as Iso

Utility curve and the different point on the curve represents the samelevel of satisfaction.

The equation Indifference curve can be written as : U = f(x,y)


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Indifference Curves: An Example

Market Basket Units of Food Units of ClothingA 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Graph the points with one good on the x-axis and one

good on the y-axis

Plotting the points, we can make some immediate

observations about preferences

-More is better


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The consumer prefers

A to all combinations

in the yellow box, while

all those in the pinkbox are preferred to A.

Indifference Curves:

An Example

Food

10

20

30

40

10 20 30 40

Clothing

50

G

A

EH

B

D


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Indifferentbetween pointsB, A, & D

E is preferredto points on U1Pointson U1are preferred toH & G

Indifference Curves:

An Example

Food

10

20

30

40

10 20 30 40

Clothing

50

U1G

D

A

EH

B


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Indifference Curve

Properties of Indifference Curve:

1. Indifference curve is down wards sloping.

2. It is Convex to the origin.

3. Higher Indifference curve represents higher level of satisfaction.

4. Two Indifference curves never intersect each other.

5. The collections of Indifference curves is known as indifferent Map.

Assumptions of Indifference Curve:

Existence of two products X and Y in a commodity space where both theproducts are normal and the consumption combinations are positive

definite.

The utility function are dependent which can be written as U = f (x,y) andI.C considers related product where both the products are substitute to eachother.


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Io

X1

X2

Io

I1

X1

X2

((X1/ (X2)

X1

X2

A

B

C

X1

X2

B > A

B = CA = C

Indifference Curve


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Indifference Curve

Assumptions of Indifference Curve:

The level of satisfaction is ordinarily measurable which meansranking of different combinations is possible according to the

preference of the consumer.

The relationship may be indifferent, i.e. if the combinations on A &B or B & C is equally preferable then the combination of A & Cmust be equally preferable to the consumer.

The relation may be transitive.

Application of the diminishing marginal rate of substitution.

(The marginal rate of substitution of X for Y (MRSx,y) is defined asthe no of units of good Y that must be given up in exchange for anextra unit of good X, so that the consumer maintains the same levelof satisfaction.)


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U2

U3

Indifference Map

Food

Clothing

U1

ABD

Market basketAis preferred to B.Market basket B is

preferred to D.

To describe preferences for all combinations of goods/services, we have a set of

indifference curves an indifference map. Each indifference curve in the map

shows the market baskets among which the person is indifferent.


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Budget Constraints

Preferences do not explain all of consumer behavior Budget constraints also limit an individuals ability to consume in lightof the prices they must pay for various goods and services.

The Budget Line

Indicates all combinations of two commodities for which totalmoney spent equals total income

We assume only 2 goods are consumed, so we do not considersavings

Let F equal the amount of food purchased, and C is the amount ofclothing

Price of food = PF and price of clothing = PC

Then PFF is the amount of money spent on food, and PCC is theamount of money spent on clothing


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ICPFP CF !

The Budget Line The budget line then can be written:

All income is allocated to food (F) and/or clothing (C)

Different choices of food and clothing can be calculated that use all

income. These choices can be graphed as the budget line

Example: Assume income of $80/week, PF = $1 and PC = $2

Assumptions:

Existence of 2 products which are close substitute and divisible in

small nos. Income (M) of the Consumer is constant.

Price of the products (Px and Py) are constant and market

determined.

Total income spend on 2 products so, No savings and No Loan

demand.


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Budget Constraints

Market

Basket

Food

PF = $1

Clothing

PC = $2

IncomeI = PFF + PCC

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80


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C

F

P

P

F

CSlope -

2

1- !!

(

(!

The Budget Line

10

20

A

B

D

E

G

(I/PC) = 40

Food40 60 80 = (I/PF)20

10

20

30

0

Clothing


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The Budget Line

As consumption moves along a budget line from the intercept, the

consumer spends less on one item and more on the other The slope of the line measures the relative cost of food and clothing

The slope is the negative of the ratio of the prices of the two goods

The slope indicates the rate at which the two goods can besubstituted without changing the amount of money spent

We can rearrange the budget line equation to make this more clear

YXP

P

P

I

YPXPI

YPXPI

Y

X

Y

YX

YX

!

!

!


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Budget Constraints

The Budget Line

The vertical intercept, I/PC, illustrates the maximum amount of Cthat can be purchased with income I

The horizontal intercept, I/PF, illustrates the maximum amount of Fthat can be purchased with income I

As we know, income and prices can change

As incomes and prices change, there are changes in budget lines

We can show the effects of these changes on budget lines andconsumer choices


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The Budget Line - Changes

An increase inincome shifts

the budget line

outward

Food(units per week)

Clothing(units

per week)

80 120 16040

20

40

60

80

0

(I = $160)

L2

(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget lineinward

The Effects of Changes in Income

An increase in income causes the budget line to shift outward, parallel

to the original line (holding prices constant).

Can buy more of both goods with more income


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The BudgetL

ine - Changes

(PF = 1)

L1

An increase in theprice of food to$2.00 changesthe slope of the

budget line androtates it inward.

L3

(PF= 2)

(PF = 1/2)

L2

A decrease in theprice of food to$.50 changes

the slope of thebudget line androtates it outward.

40Food(units per week)

Clothing(units

per week)

80 120 160

40


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The Budget Line - Changes

The Effects of Changes in Prices

If the price of one good increases, the budget line shifts inward,pivoting from the other goods intercept.

If the price of food increases and you buy only food (x-intercept),then you cant buy as much food. The x-intercept shifts in.

If you buy only clothing (y-intercept), you can buy the same

amount. No change in y-intercept. If the two goods increase in price, but the ratio of the two prices is

unchanged, the slope will not change

However, the budget line will shift inwardparallel to the originalbudget line

If the two goods decrease in price, but the ratio of the two prices is

unchanged, the slope will not change

However, the budget line will shift outward parallel to theoriginal budget line


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Consumers Equilibrium

Consumer shall be in equilibrium where he / she can maximize his / her

utility subject to his budget constraint.

Occurs when the consumer has spent all income and the marginal utilitiesper dollar spent on each good purchased are equal.

This equilibrium considers 3 basic problems of the consumer behaviour:

Equilibrium satisfaction level. Equilibrium commodity combination.

Distribution of income between two products.

Conditions:

Necessary Condition: At the equilibrium point, Slope of I.C. = Slope of B.L.

i.e. MUx / Px = MUy/Py

Sufficient Condition:

At equilibrium I.C must be convex to the origin.


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Consumers Equilibrium:

Consumer Choice

U3

D

C

Food (units per week)40 8020

Clothing(units per

week)

20

30

40

0

U1

A

B

A, B, C on budget lineD highest utility but nota

fforda

bleC highest affordableutilityConsumer chooses C


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Consumers EquilibriumAssumptions:

Existence of the 2 products in the commodity space say X and Y, whereboth the products are normal, close substitutes, divisible in small units andconsumption combinations are positive definite.

Utility levels are ordinarily measurable and ranking of the differentcombinations are possible where the utility functions are dependent, i.e. U

= f ( X , Y )

Level of income (M) and prices of the products (Px and Py) are constant.

Consumer spends his entire income for the 2 products represents theIncome Expenditure equality.

Consumers taste and preference is constant.

The relationship or the choice of the product combinations may beindifferent or transitive.

Application of diminishing marginal rate of substitution and principle ofsubstitution.


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Consumers Surplus

Consumers surplus is thedifference between the total amountof money the consumer would bewilling to pay for a quantity of acommodity and the amount he /sheactually had to pay for it and thisconcept is based on DMU.

CS = TU (P * Q), otherwise, CS = Price prepared to pay Actual

price paid.

Unit

s

MU MP CS

12

3

4

7060

44

20

2020

20

20

5040

24

00

4

Units

194 80 114


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Income and Substitution Effects A persons real income, or purchasing power, rises if with a given

absolute income, he or she can purchase more goods and services.

A fall in the relative price of a good will, and a rise in real incomecan, lead to greater purchases of the good.

The portion of the change in the quantity demanded that isattributable to a change in its relative price is referred to as theSubstitution Effect.

The portion of the change in the quantity demanded that isattributable to a change in real income, brought about by a changein absolute price, is referred to as the Income Effect.


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Income and Substitution Effects

2nd lecture-demand and consumer behavior

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