8/21/2015

1

REVIEW

1. Definitions

Utility (U)

Total Utility (TU)

Marginal Utility (MU)

Consumption Surplus (CS)

2. The law of Diminishing Marginal

Utility

Note: The level of consumer surplus is shown by the

area under the demand curve and above the ruling

market price as illustrated in the diagram below:

CHAPTER I:

THEORY OF DEMAND

- Explain customers’ behavior by

theories of demand

- Estimate demand in the future

8/21/2015

2

I. THE THEORY OF CONSUMER’S CHOICE

People are confronted with thousands of goods thatyou might buy.

Face with constraint in your financial resources

Cannot buy everything that you want.

You, therefore, consider the prices of the variousgoods being offered for sale and buy a bundle ofgoods that, given your resources, best suits yourneeds and desires

Choice is made by:

Preference

Budget

5

1. Consumer’s preference

a. Assumptions:

- Consumer can arrange, compare bundles of goods

- Consumer prefers more to less

- The comparison can be transferred A>B

B>C

A>C

8/21/2015

3

b. Indifference Curve (IC or U)

b. 1 Definition:

A curve that shows consumption bundles that

give the consumer the same level of satisfaction

b.2 Five properties of indifferent curves:

- IC has downward slope

- ICs cannot intersect

8/21/2015

4

- Their slope gets steadily flatter to the right

IC’S SLOPE GETS STEADILY FLATTER TO

THE RIGHT

Moving between 2 points on IC will result in:

∆U=0

MUx∆X + MUy∆Y = 0

As more of one good is

consumed

Consumer would prefer

to give up fewer units of

second to get additional

units of first

8/21/2015

5

- Higher indifference curves are preferred

to lower ones Consumers usually prefer more of something to less

of it

Higher indifference curves represent larger

quantities of goods than lower indifference curves.

Thus, the consumer prefers being on higher

indifference curves

- Different kinds of IC represent different preference

Indifference curves with different shapes imply

different willingness to substitute

b.3 Special cases of IC

8/21/2015

6

PERFECT SUBSTITUTES AND PERFECT

COMPLEMENTS.

- When two goods are easily substitutable, such

as Coca and Pepsi, the indifference curves are

straight lines

- When two goods are strongly complementary,

such as left shoes and right shoes, the

indifference curves are right angles

17

2. The budget line

• Income and prices together

determine the combinations

of the goods that the

consumer can afford.

• The budget line separates

the affordable from the

unaffordable.

Consider a student with a

budget of 250,000VND to spend on

meals and films.

0

1

2

3

4

5

6

0 2 4 6 8 10 12

Meals

Fil

ms

A

B

C

D

E

F

G

Price of meals is 25,000 VND;

price of films is 50,000VND.

Budget Line:

8/21/2015

7

- CHANGES CAUSED BY INCOME (HOLDING

PRICES CONSTANT)

- CHANGES CAUSED BY PRICE’S CHANGE

(HOLDING INCOME CONSTANT)o Change in Px

o Px↑: BL turn in

o Px↓: BL turn out

CONSUMER CHOICE

Given preferences and budget

constraints, how do consumers choose

what to buy?

Consumers choose combination of goods

that maximize satisfaction, given

limited budgets

Maximizing market basket:

1. Must be located on budget line

Spend all their income – more is better

2. Must give consumer most preferred

combination of goods and services

8/21/2015

8

22

III. The consumer’s choice

• The choice point is

at C

• where the budget

line is at a tangent to

an IC

• Points B and E are

also affordable but

give lower utility,

being on a lower IC.

U3

Quantity of meals

U2

U2U1

U3

U1

BL

C

E

B

The point at which utility is maximised is found by bringing

together the indifference curves (U) and the budget line (BL)

4. INCOME EFFECTS AND

SUBSTITUTION EFFECTS

Assumptions:

Preferences are complete

Preferences are reflexive

Preference are transitive

Preferences exhibit non-satiation

Indifference Curves exhibit diminishing

marginal rates of substitution

OPTIMIZATION: WHAT THE CONSUMER

CHOOSES

What happen to the choice of customer

if one of following factors change:

- Income

- Price of good (X or Y)

8/21/2015

9

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

How changes in income affect the

consumer’s choices

Higher income

Consumer can afford more of both goods

Shifts the budget constraint outward

New optimum

25

AN INCREASE IN INCOME

7

26

Quantity

of

Pepsi

Quantity of Pizza0

New budget constraint

I2

I1

New optimum

Initial

budget

constraint

Initial

optimum

1. An increase in income shifts the

budget constraint outward . . .

2. . . . raising

pizza

consumption . . .

3. . . . and

Pepsi

consumption

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

How changes in income affect the

consumer’s choices

Normal good

Good for which an increase in income

raises the quantity demanded

Inferior good

Good for which an increase in income

reduces the quantity demanded

27

8/21/2015

10

AN INFERIOR GOOD

8

28

A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is

an inferior good: When the consumer’s income increases and the budget constraint shifts

outward, the consumer buys more pizza but less Pepsi.

Quantity

of

Pepsi

Quantity of Pizza0

New budget constraint

I2

I1

New optimum

Initial budget

constraint

Initial

optimum

1. When an increase in income shifts the

budget constraint outward . . .

2. . . . pizza consumption rises,

making pizza a normal good. . .

3. . . . but Pepsi

consumption falls,

making Pepsi an

inferior good

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

How changes in prices affect the

consumer’s choices

If price of Y is reduced

You would like to substitute goods

You become richer

29

Price of one good falls

Rotates the budget constraint

outward

Income effect (IE)

Substitution effect (SE)

8/21/2015

11

A CHANGE IN PRICE

9

31

When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes

slope. The consumer moves from the initial optimum to the new optimum, which changes his

purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the

quantity of pizza consumed falls.

Quantity

of Pepsi

Quantity of Pizza0

I2

I1

Initial

budget

constraint

1. A fall in the price of Pepsi rotates

the budget constraint outward. . .

2. . . . reducing pizza consumption

3. . . . and

raising Pepsi

consumption

New budget

constraint

New optimum

Initial optimum

A

100

B500

D1,000

SUBSTITUTION EFFECT

An effect caused by a rise in price thatinduces a consumer (whose income hasremained the same) to buy more of arelatively lower-priced good and less of ahigher-priced one. consumers always switch from spending

on higher-priced goods to lower-pricedones as they attempt to maintain theirliving standard in face of rising prices.

Substitution effect is not confined onlyto consumer goods, but manifests in otherareas as well such asdemand for labor and capital.

INCOME EFFECT

As the wealth of the individual rises/ falls,demand increases/ decrease, shifting thedemand curve to the right/ lelf at all ratesof consumption. This is called the incomeeffect

Note:

- The Income Effect can be bothpositive and negative depending onwhether the product is a normal or inferiorgood

8/21/2015

12

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

Income effect

Change in consumption

When a price change moves the

consumer To a higher or lower indifference curve

Substitution effect

Change in consumption

When a price change moves the

consumer Along a given indifference curve

To a point with a new marginal rate of

substitution

34

INCOME AND SUBSTITUTION EFFECTS

10

35

-The substitution

effect (SE) —the

movement along an

indifference curve to

a point with a

different marginal

rate of substitution—

is shown here as the

change from point A

to point B along

indifference curve I1.

-The income effect

(IE) —the shift to a

higher indifference

curve—is shown

here as the change

from point B on

indifference curve I1to point C on

indifference curve I2.

Quantity

of Pepsi

Quantity

of Pizza0

I2

I1

Initial

budget

constraint

New budget

constraint

Initial optimumA

New optimumC

B

Substitution effect

Substitution

effect

Income effect

Income

effect

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

Deriving the demand curve

Quantity demanded of a good for any

given price

Initial optimum point

Initial price of the good

Initial quantity of the good

A change in price of the good (new price)

New optimum

New optimum quantity

36

8/21/2015

13

DERIVING THE DEMAND CURVE

11

37

Quantity

of Pepsi

(a) The Consumer’s Optimum

Quantity

of Pizza

0

Price of

Pepsi

(b) The Demand Curve for Pepsi

Quantity

of Pepsi0 250 750

Demand

I2

I1250

750

Initial budget

constraint

New budget constraint

B

A

1

$2

B

A

5. APPLICATIONS

5.1EFFECT OF PRICE CHANGE

38

Price Consumption

Curve traces out utility

maximizing market

basket for each price of

food.

4

U2

B

12 20

5

U3

D

Food (units

per month)

Clothing

6 A

U1

4

10

39

SUBSTITUTES & COMPLEMENTS

If Price Changes

When price-consumption curve is downward-sloping:

Increase (decrease) in price of one leads to increase (decrease) in quantity demanded of other

Cross-price elasticity of demand is positive

Two goods are substitutes

When price-consumption curve is upward-sloping:

Increase (decrease) in price of one leads to decrease (increase) in quantity demanded of other

Cross-price elasticity of demand is negative

Two goods are complements

8/21/2015

14

5.2 EFFECTS OF INCOME CHANGES

40Food (units

per month)

Clothing

(units per

month)

Income Consumption Curve

traces out utility maximizing

market basket for each income

level.

•Increase in income shifts

budget line right, increasing

consumption along income-

consumption curve.

3

4

A U1

5

10

B

U2

D7

16

U3

EFFECTS OF INCOME CHANGES

41Food (units

per month)

Price

of

food

Income increase shifts demand

curve right.

•e.g., Increase in income, from

$10 to $20 to $30, with prices

fixed, shifts consumer’s

demand curve.

$1.00

4

D1

E

10

D2

G

16

D3

H

NORMAL & INFERIOR GOODS

Income Changes

When income-consumption curve has

positive slope:

Quantity demanded increases with

income

Income elasticity of demand is positive

Good is normal good

42

8/21/2015

15

Income Changes

When income-consumption curve has

negative slope:

Quantity demanded decreases with

income

Income elasticity of demand is negative

Good is inferior good

INFERIOR GOOD

44Hamburger

(units per month)

Steak

(units per

month)

30

U3

C

Income-Consumption

Curve

…but hamburger

becomes inferior

good when income

consumption curve

bends backward

between B and C.

105

A

U1

5

20

10

B

U2

Both hamburger

and steak behave

as a normal good,

between A and B...

ENGEL CURVES

45

Engel Curves relate

quantity of good

consumed to

income.

•Slope upward for

normal goods;

backward for inferior

goods.Inferior

Normal

Food (units

per month)

30

10

Income

($ per

month)

20

4 8 12 16

8/21/2015

16

THREE APPLICATIONS

Do all demand curves slope downward?

Law of demand

When the price of a good rises, people buy less of

it

Downward slope of the demand curve

Giffen good

An increase in the price of the good raises the

quantity demanded

Income effect dominates the substitution effect

Demand curve – slopes upward

46

This particular economic paradox was

propounded by Scottish economist, Sir

Robert Giffen (after whom it's named).

when the price of necessary staple goods such

as bread, food grain, vegetables, etc., rose,

the poorer sections of the Victorian society,

who relied heavily on these basic staple

items, gave up on purchasing other goods

and concentrated all their purchasing power

on procuring the necessary staples.

This kept the demand for these good

high despite an increase in their price

A GIFFEN GOOD

12

48

In this example, when the price of potatoes rises, the consumer’s optimum shifts from point C

to point E. In this case, the consumer responds to a higher price of potatoes by buying less

meat and more potatoes.

Quantity of

Potatoes

Quantity of Meat0

I1

New

budget

constraint

1. An increase in the price of potatoes

rotates the budget constraint inward . . .

2. . . . which

increases

potato

consumption

if potatoes

are a Giffen

good.

Initial budget

constraint

A

D

B

Optimum with low

price of potatoesC

I2

Optimum with high

price of potatoes

E

8/21/2015

17

5.3 USING ALGEBRA FOR CHOOSING OPTIMUM

POINT:

Why we have to use algebra for choosing

optimum point once we can use IC – BL do to

the same thing?

Using algebra can help in explaining more precisely

Someone can blame that the result we got from IC –

BL tools based on the way of drawing

Using geometry put a constraint on the number of

good in a bundle of goods that people can choose to

optimize their utility while algebra can increase

number of goods to more than two goods

At the beginning, we start with two goods named

X and Y

- Income used for X and Y is M

- Price of X (Px), price of Y (Py)

Assumptions

M is used as follows:

M = Px.X + Py.Y

↔ M – Px.X – Py.Y = 0

• The utility function of this customer is

U= u (X,Y).

This function is used to measure the

utility of customer

8/21/2015

18

Take the derivative of function U, what we have is:

All bundles of goods in one IC bring a same level

of utility, means dU = 0:The lelf hand side of

equation is the slope of

IC (Marginal Rate of

Substitue - MRS),

the right hand side of

the equation is the rate

of MU between X and Y.

To get the optimum point, we create the function of

utility with regard to the budget:

V = u (X,Y) + λ (M-Px.X-Py.Y)

(λ is factor Lagrange)

To maximize V can happened :

From the first two equations, we have:

8/21/2015

19

II. STRANGE CUSTOMER BEHAVIOR

1. Network ExternalitiesUp to this point, have assumed people’s

demands for good are independent of oneanother

For some goods, one person’s demanddepends on demands of others and networkexternality exists Positive network externality if quantity of

good demanded by consumer increases inresponse to purchases by otherconsumers

Negative network externality: theopposite 55

NETWORK EXTERNALITIES

56

Bandwagon Effect

Desire to be in style, havegood because othershave it, indulge in fadMajor objective ofmarketing andadvertising campaigns(e.g. toys, clothing)Positive networkexternality in whichconsumer wants good inpart because others do

NETWORK EXTERNALITIES

Snob Effect

If network externality is negative, snob effect exists

Refers to desire to own exclusive goods

Quantity demanded of “snob” good higher when fewer people own it

8/21/2015

20

2. INSUFFICIENT INFORMATION

2.1 Definition:

A situation in which one party in a transaction

has more or superior information compared to

another.

This often happens in transactions where the

seller knows more than the buyer, although the

reverse can happen as well.

Potentially, this could be a harmful situation

because one party can take advantage of the

other party’s lack of knowledge

What happened if there is asymetric

information in the market?

Buyer wonder about the quality of goods so

they better set a very low price for the

goods

Buyer and seller prefer deal through a

broker

Market disappears

III. REVEALED PREFERENCES

Can determine preferences given

information about sufficient number of

choices made when prices and incomes

vary

If continue to change budget line,

individuals can tell you which basket they

prefer to others

More information revealed, the more you

can discern about preferences

8/21/2015

21

If a consumer chooses one market basket over

another, and if the chosen market basket is more

expensive than the alternative, then the consumer

must prefer the chosen market basket

- Px↓ BL turn to the

position of AC

Customer choose b

-In order to separate SE

and IE, we create A’C’

The optimum point

will be points to the right

of a or a itself (belong to

A’C’).

- If a≡c then SE = 0

Conclusion:

According to Revealed Preference, SE and IE can be

separated only if SE = 0 (when a≡c)

8/21/2015

22

IV. CHARACTERISTICS APPROACH

Assumptions:

- Customer choose goods because of the

characteristics of the goods rather than the

goods itself

The choice now is to maximize the

characteristics that a customer can achieve

- Customer use all of their income, no savings

- The customer will never saturate of the goods’

characteristics

Orange will be

considered of two

following

characteristics:

-Level of Sugar

-Level of Water

a. Characteristics Possibility Frontier

Budget for buying orange

is 90,000 VND.

-1st orange: 60,000/kg

-2nd orange: 45,000/kg

-3rd orange: 30,000/kg

ABC is the characteristics Possibility Frontier since moving along

this, customer changing in characteristics gain from their consumption

-Using all budget ,

customer has:

-1,5kg 1st orange A

-2kg 2nd orange C

-3kg 3rd orange B

8/21/2015

23

B. OPTIMUM CHOICEThe optimum point is D:

-Characteristics 1: y1+y2

-Characteristics 2: x1+x2

V. EMPIRICAL ESTIMATION OF DEMAND

Statistical Approach to Demand Estimation

Properly applied, can enable one to sort out

effects of variables on quantity demanded

“Least-squares” regression is one approach

Assuming constant price and income

elasticity:

Isoelastic demand =

Slope, -b = price elasticity of demand

Constant, c = income elasticity of demand 68

)log()log()log( IcPbaQ

- Linear model:

QD= a0Px + a1Py + a2I + a3E + a4T

Or

- Non - linear model:

QD= Pxa0 Py

a1 I a2 E a3 T a4

log QD= a0 logPx + a1 logPy + a2n logI + a3

logE + a4 logT

Using regression we can estimate a0, a1, a2, a3,

a4, a5.

8/21/2015

24

GRAVITY MODEL

- First introduce by Tinbergen (1962) and

Linnemann (1966)

- Factors used to explain trade flows between

two countries:

- Population

- Economic size(GDP)

- Distance

Other factors might included:

- FTA

- Border

Model:

LnXij = βo+ β1 lnYi + β2lnYj + β3 Dj + β4 tai + β5 Border + β6

lnPj + eij (4.1)

with:

• Xij trade flows from Vietnam to country j

• Yi is Vietnam’s GDP

• Yj country j’s GDP

• Dj is distance.

• Pj population of country j

• TA is dummy, variable

• Border is dummy variable.

• eij is noise

Attentions to do research/ starting with

choosing data:

Nominal or Real GDP

Distance can be:

Between the two capitals

Between two economic centers

Between the two largest ports of the two

countries…

8/21/2015

25

1. Market survey

- Conduct survey with many questions created

under a questionnaire

- Assessment

- Advantages: low cost, huge population can be

achieved

- Disadvantages:

- Psychological problem

How to increase the quality of market

survey???

8/21/2015

26

2. Consumer clinics

Observe customers’ behavior after giving them

an exact amount of money and put them in a

shop

2. CONSUMER CLINICS

OBSERVE CUSTOMERS’ BEHAVIOR AFTER GIVING THEM

AN EXACT AMOUNT OF MONEY AND PUT THEM IN A SHOP

- Assessment:

- Advantage

- Disadvantage

- Small population can be achieved

- Expensive

- Not in the way they use their own money

8/21/2015

27

3. TRIAL MARKET

Viettel 3G-10/2009 in HCM

city

-8/12/2009, Viettel

announced to

extend the

business strategy

nationwide