Module 3 : Demand
Allocation of limited income to maximize utility subject to a budget constraints
IMP- Income is always considered fixed cet par. An increase in income would always
impact decisions otherwise.
People pursue maximization of their interest but also products that are harmful drugs,
alcohol, cigarettes and manufacturers address these needs. Although general assumption
is that consumers know their own best interest.
3.2 Theory of consumer choice
Equilibrium (of choices) : When utility from last dollar spent on any goods EQUALS utility
received from last dollar spent on any other good.
Ie No gain in total utility .
As consumption increases total utility increases but at decreasing rate.
Marginal Utility extra utility derived from consumption of extra unit of good
Law of Diminishing Marginal Utility Marginal utility as consumption
Total utility can be by purchasing combination of goods
Ie Reallocating expenditure from low MU good to high MU goof or unit).
Equilibrium reached when MU per dollar used equal or all goods.
If MU is small for good B then
Total utility can be increased by purchasing more A until MU A declines and is equal to MUB
Examples;
Means that last glass of wine gave twice utility as last food
An increase in income that leads to more consumption would decrease both MUs but
doesnt dictate a shifts ( although there is an increase in total utility).
If price of wine decreases for same MU then;
Purchase more wine until MU wine decreases.
Plus since less food is purchased the MU is increased un till is restored
Both budget and prices affect quantities purchased.
3.3 Individual Demand
In studying demand one variable is selected and assume all other factors as constant cat
par.
Relationship between price and quantity that an individual will be willing to buy in a
period -> Individual Demand
Points are observations
Points between points are approximation
1) Important to state period. Increase in period would shift to right ie demand
2) Assumption is cet par ie all substitutes are constant
3) Demand curve shot ha at higher prices -> lower demand.
Demand curve shows hypothetical relationship.
Assumption : at cheaper prices an individual will same small amount as at higher price +
extra amount he now affords.
At cheaper prices demand curve is same but shifts to left.
Negative slope due to ;
1)
2)
1)
2)
Budget constraint/effect
Substitution effect
Higher price -> Reduction total utility -> reduction real income
2) reduction money income -> same prices but reduction in purchase.
Real income = money potential/value potential
Money income = actual cash income/budget
Eg Voucher money income
Sales discount = Rea income.
Substitution effect is always negative, inc in prices -> cheaper alternative
Income effect can be +ve or ve
Normal goods ; a decrease in real income due to inc price -> Decrease in quantity ( and
vice versa)
This is positive because income effect and quantity are in same direction
This reinforces the ve sub effect and graph is always a downward slope left to right.
Increases in real income ban be caused by increase in money income or decrease in
price.
Inferior good ; inc in real income -> decrease in purchase eg. Cheap meat.
However the ve sub effect still counteracts and exceeds the income effect slope is still
downward .
In price demand curve the VARIABLES are price and demand.
Al other factors are parameters.
Quantity -> depends on price ->dependent variable.
Price not affected by individual purchases -> independent variable.
Parameters affect position and shape of chart. Any changes -> chart changes.
Eg Shift/Change due to income parameters
Income decreases
Demand shift to left even though price is the same
Change in price -> individual moves along demand curve
Change in parameter -> curve shifts
Max utility when ;
Also as consumption : total utility but at rate.
If any price is reduced then more of this is purchased until equilibrium;
if price quantity
3.4 Market Demand
Is the sum of individual demands in the market. Market demand curve is derived from
individual dem. Curve.
However proportions of H and L are small while M is much larger and real curve
would be;
Demand for goods is classified by responsiveness of demand to price change.
3.4.1 Price Inelasticity
Proportional, change in quantity
demand
Less
<
Proportional change in price
Important we refer to proportion change only and total expenditure. Actual
price/demand relation remains ie as price inc the demand would dec.
But this doesnt explain the total exp in reference to the in P
3.4.2 Price Elasticity:
Proportion change in quantity is greater > Proportion change in price
3.4.3 Unitary Price Elasticity
Proportion change in Quantity is equal to proportion change in price
Total expenditure constant for both prince inc and dec.
Improved calculation : Since we are comparing 2 prices the average is taken. Same for
quantity.