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Explanations of the Demand Explanations of the Demand CurveCurve

& Consumer Choice& Consumer Choice

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Income effect is the impact on a consumer’s real income of a change in the price of a product and consequently the quantity of the produce demanded.

The Income and Substitution EffectThe Income and Substitution Effect combine to make combine to make a consumer able and willing to buy a consumer able and willing to buy moremore of a specific of a specific

good good at a low priceat a low price than at a high price. than at a high price.

When the price of a good decreases, people can buy more with the same income.

When the price of a good increases, people need to buy less with the same income.

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Substitution effect is the impact that a change in the product’s price has on its relative expensiveness and consequently on the quantity demanded.

When the price decreases, the good is less expensive relative to other similar goods. We substitute with the now lower priced good.

When the price increases, the good is more expensive relative to other similar goods. We substitute with the now lower priced good.

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What is Utility?What is Utility?

The satisfaction or enjoyment a person

obtains from consuming a good

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What is a Util?What is a Util?

A hypothetical unit used to measure how much utility a person obtains from consuming a good

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Marginal UtilityMarginal Utility

The change in total utility a person derives from consuming an additional unit of a good

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Total UtilityTotal Utility

The total number of utils a person derives from consuming a specific quantity of a good

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TU and MUTU and MUQ TU MU0 01 10 102 18 83 24 64 28 45 30 26 30 07 28 -2

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Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility

After a point, as more of a good is consumed, the marginal utility (MU) a person derives from each additional unit diminishes.

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Tot

al U

tility

Quantity

TU

Total UtilityTotal Utility increases at a increases at a diminishing rate, reaches a diminishing rate, reaches a

maximum and then declines.maximum and then declines.

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Mar

gina

l Util

ity

Quantity

MUMU

Marginal UtilityMarginal Utility diminishes with diminishes with increased consumption, reaches increased consumption, reaches zero satisfaction and then zero satisfaction and then becomes negative.becomes negative.

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Marginal Utility diminishes with increased

consumption, is zero where total utility is at a

maximum, and is negative when Total Utility declines.

When Total Utility is at its peak, When Total Utility is at its peak, Marginal Utility is zero.Marginal Utility is zero.

MargInal

UtIlIty

MUUnit Consumed

Unit Consumed

Total

Uti lity

TU

Marginal Utility reflects the Marginal Utility reflects the change in total utility change in total utility so it is so it is negative when Total Utility negative when Total Utility

declines.declines.

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Demand CurveDemand Curve

D

P1

Q1

P2

Q2

P

Q

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Why does MU = P

explain the downward sloping demand curve?

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If you are hungry for a If you are hungry for a hot dog, how many hot hot dog, how many hot

dogs will you buy?dogs will you buy?

Up to where MU = P

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Why?Why?

Because if MU > P you will buy another hot dog

If MU < P you will not buy that last hot dog

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P1

P2

Q1 Q2

MU

At P1, consume to Q1, since MU > P up to that point, at P2, consume to Q2, etc.

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Consumer equilibriumConsumer equilibrium

Now, think about how to allocate income among 2

or more goods or services!

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Consumer equilibrium condition

Consumer equilibrium condition

Purchase good X and good Y in amounts such that

MU X = MU y

P x P y Why?

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Utility-Maximizing RuleUtility-Maximizing Rule——Consumer EquilibriumConsumer Equilibrium

The consumer’s money income The consumer’s money income should be allocated so that the last should be allocated so that the last dollar spent on each product dollar spent on each product purchased yields the same amount of purchased yields the same amount of marginal utility.marginal utility.The rational consumer must The rational consumer must compare the extra utility with its compare the extra utility with its added cost.added cost.

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UUtiltil iittyy--MaxMax iimmiziziinngg wwiitthh IInncocommee ofof $10$10

UUninittss PProrodduucct At A $1$1 PProrodduucct B $2t B $2

MUMU oror utilutil ss MUMU//$$ MUMU oror utilutil ss MUMU//$$

FiFirrstst 1010 1010 2424 1212

SSecondecond 88 88 2020 1010

TThihirrdd 77 77 1818 99

FFourourtthh 66 66 1616 88FiFifftthh 55 55 1212 66

SiSixxtthh 44 44 66 33

SSeveneventthh 33 33 44 22

MU of Product A = MU of Product BPrice of A Price of B

How many of A and how many of B? What is the combinations of A and B that can be had with $10?

Answer: 2 units of A and 4 units of B MU of Product A = MU of Product B

Price of A Price of B8 = 16$1 = $2

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Assume you are not in equilibrium… say thatAssume you are not in equilibrium… say that

MU x > MU y

P x P y

What would you do??

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Purchase more of X (due to its greater satisfaction per dollar),

and less of Y

Purchase more of X (due to its greater satisfaction per dollar),

and less of Y

But… more of X reduces MUX and less of Y

increases MUY so we are heading back to

equilibrium!!

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For more than 2 goods, the equilibrium condition

becomes…..

For more than 2 goods, the equilibrium condition

becomes…..

MUx/Px = Muy/Py = Muz/Pz

= …….for all goods

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In other words, when is your Total Utility maximized?

When the When the lastlast dollar dollar spentspent on each good yields on each good yields the the samesame marginal utility marginal utility