Chapter 8 Demand Theory

1
Chapter 8Demand Theory

• Utility theory
• Very abstract but helps understanding many
  societal issues
• What we are willing to pay for a product or a
  services depends on how satisfied we feel when
  consuming the product.
• What is utility
• Def Ability of a product / service to satisfy a
  person's wants. i.e. It is a measure of
  satisfaction
• Problem to maximise societys utility must
  quantify satisfaction gained from consumption and
  there is no such measure. But for our example, we
  will use the imaginary unit of measure called
  UTILS

2
Demand theory cont.

• Total and Marginal Utility
• Total utility (TU) total utils a consumer
  derives from consuming products and services.
• Marginal utility (MU) additional utility that
  one gets from consumption of the last unit
  consumed at a particular time.
• Curve of TU Change in TU MU
• Change in Q

TU
MU
A
A
Q
Q
3
Demand theory cont.

• Law of diminishing marginal utility
• As more of a product is consumed, the
  marginal utility gained from its consumption will
  drop.
• Aside Though generally more is better, the more
  of something we have the more satisfied we feel
  when it comes to that particular good or
  service like quenching a thirst.

4
Demand Theory Cont.Consumer Equilibrium

• In demand theory we have to consider the point
  where consumer maximises his/her utility.
• To answer this question, we must consider
• The budget with which the consumer is faced
• Satisfaction received from consumption of goods
  and services
• Note we assume that for the consumer to be
  completely satisfied, the entire must be
  exhausted. So what about savings?

5
Demand Theory Cont.Consumer Equilibrium

• ? Where will consumer find maximum satisfaction
  given the budget he/she is faced with
• Example

6
Demand Theory Cont.Consumer Equilibrium

• E.G.
• Consumer Equilibrium is found where MU_X per Rand
  MU_Y per Rand
• i.e. MU_X/P_X MU_Y/P_Y
• Alternatively it is the same as MU_X/MU_Y
  P_X/P_Y
• How does this translate to demand curve?
• Must ask what happens when there is a changes in
  the price of a product.

7
Demand Theory Cont.Consumer Equilibrium

• Take Equation MU_X/MU_Y P_X/P_Y
• E.G Demand for Cashews
• Let X Cashews and Y all other products taken
  together.
• P_Y average price of all other products
• What happens if all other products price remains
  the same BUT there is an increase in price of
  cashews?

8
Demand Theory Cont.Consumer Equilibrium

• MU_X/MU_YltP_X/P_Y ( RHS is greater than LHS)
• BUT UNTIL THE CONSUMER ADJUSTS CONSUMPTION, THE
  LHS REMAINS UNCHANGED AND THE ABOVE CONDITION
  CONTINUES TO HOLD.
• But this condition does not maximise utility, as
  was previously shown. To restore equilibrium,
  MU_X must increase to make MU_X/MU_Y bigger.

9
Demand Theory Cont.Consumer Equilibrium

• But Law of diminishing marginal utility tells us
  that for marginal utility to rise, less of a
  product must be consumed.
• Therefore less cashews must be bought to increase
  its marginal utility. Thus MU_X increases. At the
  same time, as consumption of cashews decreases,
  consumption of other things must increase budget
  must be completely spent. Therefore MU_Y fall and
  LHS increases until balance is restored at
  equilibrium.

10
Demand Theory Cont.Consumer Equilibrium

• The above example leads to the basic prediction
  of demand theory
• A rise in the price of a product( if all other
  things are held constant) will lead to a decrease
  in the quantity of the product demanded by each
  consumer.
• Hence the demand curve is downward sloping.

11
Demand Theory cont.

• MU and Demand Curve
• Def. Demand Curve
• Quantity consumers are willing to buy at
  different price ( a price schedule).
• Equal to positive section of the MU curve.
• Assume marginal utility is equal to prices.

12
Demand Theory cont.
Marginal Utility
Price
MU3
P3
MU2
P2
MU1
P1
X3
X2
X1
X3
X2
X1
Quantity
Quantity

• Assuming MU Prices, if X1 units of a product
  are consumed, MU MU1 which is by definition
  P1.
• At price P1, consumers will be willing t buy X1
  units of the product.
• MU value that a consumer places on a product and
  what he is willing to pay for it.

13
Demand Theory cont.

• Characteristics of Demand curve
• Shape of demand curve is affected by presence of
  close substitutes.
• more elastic if there are close substitutes
• Less elastic if there are no close substitutes
• This implies that
• MU drops only slightly if there are close
  substitutes
• MU drops sharply if there are no close
  substitutes
• Refer to chapter 6 on elasticities.

14
Demand Theory cont.Other Concepts

• Consumer Surplus
• Def difference between what a consumer is
  willing to pay for a product and the actual price
  that is paid

Consumer surplus
Price
Market Determined Price
A
A
B
B
3
2
1
0
Quantity
15
Demand Theory cont.Other concepts

• Producer Surplus
• Def difference between the amount a producer
  receives for a product and the amount that he/she
  is willing to sell the product (Lilac Triangle).

Price ( R )
Supply
Market Determined Price
B
A
Quantity
1
2
3
16
Demand Theory cont.Other Concepts

• Paradox of Value
• Why is an essential product like water so cheap
  and a non-essential product like diamond so
  expensive?
• Answer Marginal Utility and consumer surplus
• Water is consumed until thirst is quenched. When
  quenched, there is no more need for the watergt
  MU is very low.
• But in an all or nothing situation, what one is
  willing to pay for water is high thus water has a
  huge consumer surplus.
• Total value of water is higher than marginal
  utility and price.

17
Demand Theory cont.Other Concepts cont.

• For a diamond, total utility, marginal utility
  and price are almost identical.
• MU for diamond much higher as people do not buy
  diamonds as often as they drink water
• Marginal utility indicates what you are willing
  to pay for the product thus the exchange value (
  price) is also high.
• Thus the consumer surplus of diamonds will be
  low.

18
Demand Theory Income and Substitution Effects

• Consider what happens when price of a product
  falls
• Purchasing Power has increased because the
  product is cheaper ( we can buy more of it).
• But 2 things happen simultaneously
• Income effect
• Substitution Effect

19
Demand Theory Income and Substitution Effects

• Income effect
• With a fall in price, with the same about of
  money, more of a product can be purchased.
  Therefore the Purchasing Power relative( real)
  Income has increased.
• With the increase in purchasing power, consumer
  can buy more of the product that had a price
  change and other products.
• The change in the quantity of Ice cream demanded
  due to consumers reaction to increased real
  income is called INCOME EFFECT

20
Demand Theory Income and Substitution Effects

• Substitution Effect
• Must isolate the effect of just substitution due
  to price change and as a result must keep
  purchasing power constant. The level it was at
  prior to price change. This involves reducing
  consumer money income ( to maintain purchasing
  power
• With constant purchasing power, if consumer
  maintains his behaviour, he/she will not be
  maximising utility.
• Why?

21
Demand Theory Income and Substitution Effects

• Substitution Effect Continued
• MU_X/MU_Y gt P_X/P_Y because the price of X has
  fallen.
• To restore equilibrium, consumer must increase
  consumption of the product that had a price fall
  so as to reduce the marginal utility of that
  product. In addition must reduce consumption of
  other goods.
• The change in the quantity of Ice cream demanded
  due to consumers reaction to decreased price but
  constant purchasing power is called SUBSTITUTION
  EFFECT