Transcript
‘Module 3 - Demand
3.1 Introduction
Households try to maximize utility subject to a budget constraint
Firms try ot maximize profit by hiring resources to produce the goods and services consumers want most
For the purposes of this discussion, household = individual
3.2 The Theory of Consumer Choice
Households will change their expenditure pattern until it maximizes its utility
That occurs when the utility from the last dollar spent on any good or service just equals the utility that would be received from the last dollar spent on any other good or service
Marginal utility is the extra utility derived from consuming an additional unit of a good
Marginal utility decreases as the consumption of a good increases – this is the Law of Diminishing Marginal Utility
Diminishing marginal utility means that an individual can increase total utility by purchasing a combination of goods and services rather than by allocating the budget to one good only
Total utility can be increased by switching expenditure from goods with low marginal utility to those with high until the marginal utility from one equals the other
What if one good (A) is twice as expensive as another (B) – how do we maximize total utility then? In this case the last unit of good A consumed has to yield twice the level of utility of the last unit of good B consumed. Put another way:
To maximize total utility:
Marginal Utility of Good A = Marginal Utility of Good B = ….Marginal Utility of Good Z
Price of Good A Price of Good B Price of Good Z
or: MUa = MUb = …=MUz
Pa Pb Pz
If MUa > MUb
Pa Pb
to increase total utility he should buy more of Good A and less of B, the law of diminishing returns will them reduce MUa and increase MUb until:
MUa = MUb
Pa Pb
Example:
You have $10 to spend on Wine at $1/glass and salmon sandwiches ar $0.50 a sandwich. To maximize utility, the last glass of wine must yield twice the utility of the last salmon sandwich.
Both income (budget) and prices effect the quantities of goods that you buy
3.3 Individual (or Household) Demand
The quantity of a particular good that an individual buys depends on many factors e.g. its price, price of alternatives, income etc.
To isolate and measure the influence of any factor on potential purchases of a particular good, its necessary to hold constant all other factors affecting the purchase of that good – this is what we do to measure demand
cet. par. is the latin term for keeping things equal or the same
The individual demand for a good is the relationship between the price of a good and the quantity of a good that an individual would be willing to buy in a given time period
A demand curve shows a hypothetical relationship concerning what our individual would be preapared to buy at each price, at each time period. cet. par – it ignores other factors that may effect demand e.g. the price of substitute goods
Demand curve typically is negatively inclined to the price axis (lower prices mean higher quantities) because of a combination of two factors:
at a higher price, a constrained budget or income results in fewer unit sold (income effect).
at a higher price, an individual substitutes relatively cheaper goods (substitution effect)
A price rise lowers an individuals total utility because he buys less of that good ie. a loss of Real income
Similarly, a reduction in money income (budget) results in a loss of total utility
Example:
A household buys chicken as well as meat and fish. If the price of chicken reduces then more chicken is bought not only because real income has risen but also because it will be substituted for the relatively more expensive foods such as steak.
Substitution effect is always negative, because a price increase means a decrease in quantity purchased as cheaper goods are substituted for it
Income Effect is positive for normal goods, i.e. an increase in real income due to an increase in budget or a decrease in price will lead to an increase in demand for a normal good
So for normal goods the negative substitution effect re-inforces the positive income effect, causing the downward demand curve
An inferior good is one for which the quantity purchased falls when real income rises i.e. the income effect is negative for inferior goods
An increase in real income could be caused by an increase in money income (budget) while all prices remain constant, or by a decrease in prices where money income remains fixed
The substitution effect normally outweighs the income effect, and so even for inferior goods, the demand curve slopes down
Example:
Margarine is an inferior good, if the price of margarine falls then more households use it instead of butter thus causing an increase in real income. This may result in some households switching back to butter, but not enough to outweigh the original substitution effect.
A Giffen good is one in which a large income effect outweighs the substitution effect – e.g. in 19th century Ireland the price of potatoes fell causing an increase in real income. Potatoes (the cheaper good) were substituted for other more expensive vegetables. So the drop in the price of potatoes caused less potatoes to be purchased
In the demand curve, price is the independent variable, quantity the dependent variable and all the other factors that influence both (which are kept constant) are termed parameters
Shift in parameters like a households taste, preference or income causes a shift in the demand curve
How does the demand curve relate to utility maximization?
Lets say you are in equilibrium (i.e. maximizing utility) in a two good (wine and sandwiches) world
MUw = Mus
Pw Ps
lets presume that at thos prices MUw = Mus = 4
Pw Ps 1
Wine reduces to $0.50 per glass => MUw = 8
Pw 1
So the last $1 spend on wine now yields twice as much utility as you can buy two glasses instead of one. The net gain in utility in buying wine rather than sandwiches is 4 (8-4). You continue to reallocate your resources to wine until once more
MUw = Mus
Pw Ps
Hence the demand curve for wine will be negatively inclined to the x axis
The individual demand for any product can be assumed to have a negligible influence on both price and quantity bought and sold for that good – total market demand however does
3.4 Market Demand
The Market Demand for a good is the sum of demands for that good of the individuals who comprise the market
A Market Demand curve is derived from individual demand curves
3.4.1 Price Inelasticity
A good is price-inelastic when, as price changes, the proportional change in the quantity demanded is less that the proportional change in price
With P = initial price and Q = initial quantity:
Q < P
Q P
If E is a measure of price Inelasticity then:
E= Q/Q <1 (normally ignore the negative sign that is caused by price and quantity moving in
P/P opposite directions)
So if a price change from $1 to $1.10 results in a quantity change from 100 to 80, the elasticity is:
E= Q/Q = 20/100 = .2/.1 = 2
P/P .1/1
So if a price change from $1.10 to $1.0 results in a quantity change from 80 to 100, the elasticity is:
E= Q/Q = 20/80 = 2.75
P/P .1/1.1
3.4.3 Unitary Price Elasticity
A good has unitary price elasticity when, as price changes, the proportional change in the quantity demanded exactly equals the proportional change in price
So, in this case total expenditure remains the same whether it’s a price increase or decrease
In the last two example in the previous section we saw how the price elasticity varied depending on whether there was a price increase or decrease – this normally is insignificant if the good is elastic or inelastic
In the case of unitary elasticity, however, this may have a significant effect hence we should use a different formula:
E’ = (Q1-Q2)/((Q1+Q2)/2)
(P1-P2)((P1+P2)/2)
So if a good’s price increased from $0.8 to $1 caused a decrease in quantity from 125 to 100
E’ = (25)/225/2 = 0.22/0.22= 1
0.2/1.8/2
What happens if the opposite happens, a price decrease:
E’ = 1 as well
3.4.4 Variation in price elasticity of Demand
414020137160E=Infinity
00E=Infinity
478790-444500Price
522605641350020
81597525400E>1
00E>1
104521097155E=1
00E=1
128460522860E<1
00E<1
1676400138430E=0
00E=0
4787909588500
100 Quantity
The E= infinity is because any in the equation for E, the Q will be zero and hence dividing by zero gives infinity
The above figure shows that even with a straight line demand curve, the value of E moves from infinity all the way to 0 as you move left to right
The are three types of demand curve where E remains constant
Perfectly inelastic (demand curve is a vertical line)
Perfectly elastic (demand curve is a horizontal line)
Unitary elasticity (shown below)
478790-444500Price
69659511176000
124079069215E=1, all the way around the curve
00E=1, all the way around the curve
4787909588500
Quantity
Note: the price elasticity of demand does not directly relate to the steepness of the curve, because the scales on the axes could differ
Goods which are necessities are usually price inelastic, as are goods which account for a small proportion of an individuals budget (e.g.stamps)
goods which have close substitutes are usually price elastic
3.4.5 Other Elasticities of Demand
Cross elasticity of demand is a measure of how a price change in one good can effect the quantity demanded of another:
Qa/Qa this varies from minus infinity to plus infinity
Pb/Pb
Complementary goods have negative cross elasticity
Subsitute goods have a positive cross elasticity
Income elasticity is the measure of how much quantity demanded changes as income change cet. par.
Income elasticity = Q/Q
Income/Income
There are five important values for income elasticity
negative, demand for a good decreases as income increases e.g. inferior goods like cheap meat
zero, no change
between 0 and 1, quantity increase is proportionally smaller than income increase
1, both are proportional
>1, quantity demanded increases more than income e.g. housing
3.5 The Theory of Consumer Behavior and the Real World
Important to companies to know what the likely demand for their products will be
First step – identify the characteristics of the type of people who consume the product e.g. demographics, likes, dislikes
Then estimate the elasticities mentioned in previous section
Collect and analyze the data to determine if the demand curve will be shifting right or left or remain as it is
Predicting demand is difficult as external factors may effect the demand curve e.g. worldwide recession
Govt also wants to know the demand for services and taxes
When taxes are high
it effects households disposable income
it also effects work effort
Taxes on goods and services effect the distribution of real income
Review Questions
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