Summary: Theory of Consumer Demand
TOPIC 2: Theory of Consumer Demand
Students should be able to:
1. explain the concept of utility;
2. explain the law of diminishing marginal utility and the limitation of marginal utility
theory;
3. explain the meaning of indifference curves and budget lines;
4. explain consumer equilibrium using the marginal utility approach;
5. explain consumer equilibrium using the indifference curve approach;
6. isolate the income and substitution effects of a price change;
7. explain effective demand;
8. derive the demand curve using both the marginal utility and indifference curve
approaches;
9. differentiate among normal, inferior and Giffen goods;
10. distinguish between shifts of the demand curve and movements along the curve;
11. identify the factors that affect demand;
12. explain the meaning of consumer surplus;
13. explain price elasticity, income elasticity and cross elasticity of demand;
14. calculate numerical values of elasticity;
15. interpret numerical values of elasticity;
16. assess the implications of price elasticity of demand for total spending and revenue;
17. state the factors that determine the price elasticity of demand.
CONTENT
1. Utility: total, marginal, cardinal (marginalist approach), ordinal (indifference curve
approach).
2. (a) Explanation of diminishing marginal utility.
(b) The main assumptions and limitations of Marginal Utility Theory.
3. Indifference curves and the budget constraint (budget lines).
4. The law of equi-marginal returns.
5. The point of tangency of the budget line to the indifference curve.
6. Income and substitution effects of a price change.
7. Effective demand.
8. Deriving the demand curve using the marginal utility as well as the indifference curve
approach.
9. Normal, inferior and Giffen goods using the indifference curve approach.
10. Shift versus movements along demand curves.
11. Price and the conditions of demand.
12. Consumer surplus including graphical representations.
13. Price, income, and cross elasticities.
14. Calculation of values of elasticity.
15. Classification and interpretations (sign and size); including the drawings and
interpretations of graphs.
16. The implications of price elasticity of demand for total spending and revenue.
17. Factors that determine the price elasticity of demand.
NOTES
Consumers are the groups of individuals who consume final goods and services as a means
of fulfilling their wants or desires. The term consumer demand accounts for the total
quantity of a good or service purchased over a specific period of time.
As price moves (decreases) from Pa to Pb, quantity increases from Qa to Qb, vice versa.
In analyzing consumer behavior, 2 assumptions can be made:
Consumers are utility maximizers. Consumers try to gain as much satisfaction or utility
possible from the goods and services they choose to consume.
Consumers are rational. They aim not only to attain the greatest level of utility from the
consumption of goods and services, but they also aspire to do so at the least possible cost.
There are 2 approaches or theories which are used to explain how consumers establish
their level of consumption.
The Cardinalist Approach (The Marginalist Approach/ the Marginal Utility Theory)
The Ordinalist Approach (The Indifference Curve Theory)
The Cardinalist Approach/ Marginal Utility Theory
This theory was developed by an American economist, Alfred Marshall. It is based on
quantifying or measuring the utility derived from consuming a good, using cardinal
numbers. E.g. I get 10 utils from consuming my 2nd piece of chocolate.
Assumptions:
The consumer is rational
Satisfaction can be measured
Diminishing marginal utility exists
There is constant utility of money.
Total utility: is combined utility obtained from the consumption of a number of units of a
good or service.
Marginal utility: is the extra utility obtained from the consumption of the last unit of a good
or service. ∆TU/ ∆Q
A thirsty man drinks 6 glasses of lemonade in a short space of time.
State the relationship between quantity and TU/MU.
Draw the TU and MU curves.
The law of diminishing marginal utility:
Deriving the demand curve:
We can derive the demand curve from the marginal utility function. In order to do that, it is
assumed that MU = P.
It would be irrational to consume at quantity where MU is negative since he gets no
satisfaction from that point.
Consumer equilibrium.
The condition necessary for a utility maximizing individual to achieve consumer
equilibrium occurs when:
MU = P Here consumption should remain constant. (Equilibrium)
MU ˃ P Here consumption should increase to maximize utility.
MU ˂ P Here consumption should decrease to maximize utility.
To maximize utility, this condition must hold for each good a consumer buys. So, if we have
2 goods, lemonade and chocolates, we can say that:
MU Lemonade = P lemonade
MU chocolate = P chocolate
We can also say:
MUL/ MUC = PL/ PC
It can be rearranged as:
MUL/ PL = MUC/ PC This is called the equi-marginal utility principle.
Limitations of the MU theory:
Assumption of cardinal utility: it is doubtful whether you can measure satisfaction. Utility or
satisfaction from the consumption of a service is a human sensation which would vary
among consumers.
Assumption of the constant utility of money: it is unrealistic. It is not a good measuring rod
because money means different things to different income groups.
The law of diminishing MU: it has been established from introspection, it is a psychological
law that must be taken for granted.
There is no law saying that people behave rationally. No one does.
The Ordinalist Approach (Indifference Curve Theory)
The second theory that explains the law of demand is the Indifference Curve Theory. It is an
alternative way of looking at the relationship between P & QD.
Assumption:
A consumer gains the same total pleasure or satisfaction from any of the combinations or
bundles of 2 goods.
Draw the indifference curve.
The consumer experiences a diminishing marginal rate of substitution of lemonade for
chocolate when, as he gives up chocolate, the last unit sacrificed means more and more to
him while the extra glass of lemonade gained means less and less.
Indifference curve map:
IC3 is preferred over IC 1 and IC2. IC2 is preferred over IC1. Each point on IC2 yields a
greater total satisfaction for our consumer.
There are an infinite amount of ICs that would please the consumer.
IC would never cross. Consumers cannot be equally happy with 2 combinations
More is always preferred over less.
The point of satiation is never reached.
Budget Lines:
It shows the maximum quantities of 2 goods which a consumer can buy given the size of his
income and the prices of the 2 goods.
The BL represents the budget constraint facing the consumer.
It is the combination of 2 products which can be purchased with a given level of income.
Price of both goods changing
Price of both goods changing with a bigger price change in good Y
Price of X changing
Price of both goods changing proportionally.
Consumer equilibrium:
This occurs where the BL is tangential to the IC.
To maximize utility and achieve consumer equilibrium, an individual must choose a
combination of goods on the furthest IC he can reach.
IC – what a consumer MIGHT do
BL – what a consumer CAN do
Consumer equilibrium is located where the BL just touches the furthest IC.
Substitution and Income Effects:
Substitution effect: if the price of a good falls, consumers will buy more of that good and less
of another. They will substitute the other good to buy more of this good whose price has
fallen.
Income effect: this related to the fact that whenever the price changes of any good which a
consumer buys, his real income changes (purchasing power). When prices falls for a good,
the consumer feels better because they can purchase more.
The nature of the income effect depends on whether the good is normal or inferior. A
normal good is one for which demand increases when real income rises. The opposite is
true for an inferior good. Demand falls when real income rises.
exp
normal at low good becomes
levels of Y inferior at high levels of Y
0 Y
Demand curve for an inferior good:
O QD
Direction and size of the substitution and income effect:
When the price changes for a good, consumers respond by changing the quantity of
consumption. A price change is made up of the SE and IE. The SE and IE helps to show the
size and direction of a price change.
If the price falls for a good:
Search the definition of a Giffen good and give an example.
Normal good: the demand curve is downward sloping, showing that more is demanded at
lower prices. Because of this the SE and IE of a price change work in the same direction and
reinforce each other.
Inferior good: IE works in the opposite way to the SE. IE is smaller than SE.
Giffen good: there are goods that are inferior but the IE will be stronger than the SE.
demand curves for a Giffen good are upward sloping showing that as P drops, QD also falls.
All Giffen goods are inferior, but not all inferior goods are Giffen.
The size and direction of the SE and IE can be shown graphically:
The Hicksian Approach:
For a Normal good (Price Fall of good X):
Begin with an original BL.
For a price fall of Good X, pivot the BL outward, showing more can be bought of Good X.
There should be 2 eq. at this stage – an eq. on the original BL and the original IC and an eq.
on the Pivoted BL and the new IC.
A price fall for an inferior good (on the X axis):
The SE and IE of a Giffen good (Price fall of Good X):
Demand
Demand is the quantity of a good or service that consumers are willing and able to
purchase at a given price at a particular point in time.
The demand schedule:
the demand schedule is a tabular representation of the relationship between the price of a
commodity and the quantity of it demanded. The table below shows the demand schedule
for chocolate:
As the price rises, the quantity demanded falls, other things being equal (ceteris parbis).
Draw the demand curve.
The demand curve is downward sloping, showing the negative relationship between price
and quantity demanded. This relationship holds true for all normal and inferior goods.
Movements along the demand curve:
This is brought about by a change in the price of the good or service. As price changes, QD
changes.
A fall in price results in an increased QD called an extension of demand.
An increase in price results in a decreased QD which is termed a contraction in demand.
Shifts of the demand curve:
The demand curve can shift either to the right or to the left. A rightward shift shows that
there is an increase in quantity demanded at all price levels and is termed an increase in
demand.
What are the conditions of demand?
Income: when income increases, demand will also increase, causing the demand curve to
shift to the right from D1 to D2. When income decreases, demand decreases and the
demand curve shifts to the left from D1 to D3.
Change in price of other goods:
Advertising
Increase/decrease in population
Government legislation
Product quality
Consumer/Producer expectations.
Elasticity:
Elasticity helps us to determine the slope or steepness of the demand curve. There are 3
types of elasticity of demand: price, income and cross elasticity.
Elasticity is needed because the slope of a demand or supply curve is not always an accurate
indicator of the extent to which households or firms respond to a price change.
Elasticity generally refers to the degree of responsiveness of one variable to changes in
another variable.
Price Elasticity of Demand (PED):
PED is the degree of responsiveness of the QD of a commodity to changes in its price. It is
measured by:
The numerator is called the dependent variable and the denominator is called the
independent variable. The answer is always negative (because of the inverse relationship
between P & QD) so the sign is often ignored.
e.g.
e.g.
Degrees of Price Elasticity:
“The elasticity or responsiveness of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in price and diminishes much or
little for a given rise in price”.
However, some particular values of elasticity of demand have been explained as under:
1. Perfectly Elastic Demand:
2. Perfectly Inelastic Demand:
3. Unitary Elastic Demand:
4. Relatively Elastic Demand:
Relatively elastic demand refers to a situation in which a small change in price leads to a big
change in quantity demanded. In such a case elasticity of demand is said to be more than
one (ed > 1). This has been shown in figure 4.
In fig. 4, DD is the demand curve which indicates that when price is OP the quantity
demanded is OQ1. Now the price falls from OP to OP1, the quantity demanded increases
from OQ1 to OQ2 i.e. quantity demanded changes more than change in price.’
5. Relatively Inelastic Demand:
Under the relatively inelastic demand, a given percentage change in price produces a
relatively less percentage change in quantity demanded. In such a case elasticity of demand
is said to be less than one (ed < 1). It has been shown in figure 5.
All the five degrees of elasticity of demand have been shown in figure 6. On OX axis, quantity
demanded and on OY axis price is given.
Elasticity of demand and Total revenue:
It is important to understand the relationship between total revenue and elasticity. This
knowledge is important to producers when determining the prices of their goods and
services. Total revenue = P X Q
Elastic:
P
12
10 D
0 80 100 QD
12X80 = $960
10x100= $1000
As price increases, total revenue decreases.
Inelastic:
P
15
10 D
0 8 10 QD
10X10= $100
15X8= $120
Total revenue increases as price increases.
Unitary:
P
6
0 4 6 QD
6X4 = 24
4X6 = 24
When price increase, quantity increases by the same amount. Changes in price will cause
your revenue to stay the same.
Determinants of price elasticity of demand:
Percentage of income spent on the good: goods or services upon which households spend a
large proportion of their income tend to be more elastic than small items, such as salt, upon
which only a fraction of income is spent.
Habit forming goods: goods which consumers become addicted to tend to be inelastic in
demand. E.g. cigarettes, alcohol, drugs, newspaper.
Time: demand is more elastic in the long run than in the short run because it takes time to
respond to a price change.
Durability: the greater the durability, the more elastic the good is.
The number of uses: more uses, more elastic the good.
Importance of PED:
When a firm believes demand is elastic, it would expect a price rise to reduce total revenue,
though not necessarily to reduce total profit.
For highly elastic goods, the firm possess little market power to raise price.
Income elasticity of demand (YED):
It measures how responsive demand is to changes in income.
The sign is important here.
Types of goods:
Normal: the more income one has, the more one buys
Inferior: as income increases, the demand for the good decreases.
Degrees of YED:
Importance of YED:
When economic growth is taking place and real income and living standards are rising,
demand for inferior goods will fall while demand for normal goods and especially superior
goods or luxuries will rise.
A firm should diversify away from inferior goods in a declining market, expanding instead
into the production of goods for which demand is likely to grow faster than income.
Cross Elasticity of Demand (XED):
It measures the responsiveness of demand for one commodity to changes in the price of
another good.
XED between 2 goods and services indicates the nature of the demand relationship between
2 goods. The 3 possibilities are:
Joint demand: (complementary goods). They always have a negative XED showing that a
rise in the price of one good results in less being demanded of the good in joint demand.
Competing demand: (substitutes). The XED between 2 goods which are substitutes for each
other is always positive. A rise in the price of one good causes demand to switch to the
substitute good whose price has not risen.
No discernable demand relationship: XED between the 2 goods will be zero. A rise in the
price of one good will have no measurable effect upon the demand for the other good.
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