Demand and Consumer Choice

1. Choice and Individual Demand
   1. Postulates of Demand Theory
      1. The Individual (or household) is the unit of analysis in demand theory
      2. The basic assumptions of Demand Theory
         1. Limited Income and wealth necessitate choice.
         2. Consumers make decisions purposefully.

            Consumer's goal is to maximize utility. Utility is the satisfaction received from consuming a good or combination of goods.

         3. One good can be substituted for another.
         4. Consumers must make decisions without perfect information, but knowledge and past experiences will help.
         5. The law of diminishing marginal utility applies: As the rate of consumption increases, the utility derived from consuming additional units of a good will decline.

            Marginal Utility--The change in total satisfaction associated with consumption of 1 additional unit of any good, ceteris paribus.

   2. Marginal Utility and Consumer Choice.
      1. Consumer choices, like other economic decisions, are influenced by changes in benefits and costs.
      2. Given a fixed income and specified prices for the commodities to be purchased, consumers will maximize their satisfaction (or total utility) by ensuring that the last dollar spent on each commodity purchased yields an equal degree of marginal utility.

         Example: Chicken McNuggets

         Number of McNuggets Consumed	Total Utility Derived from consuming McNuggets	Marginal Utility
         0	0
         1	40	40
         2	70	30
         3	90	20
         4	105	15
         5	115	10
         6	123	8
         7	128	5
         8	130	2
         9	130	0

         Utility maximization Rule: Given your budget, consume those goods first that maximize the marginal utility per dollar spent.

         Consider two goods, Food and Clothing. The price of food per unit is $20 and the price of clothing per unit is $10. Your income is $70. Which combination of food and clothing will maximize total utility?

         Food: Price=$20 each				Clothing: Price=$10 each
         Qty	Total Utility	Marginal Utility	MU/Price	Qty	Total Utility	Marginal Utility	MU/Price
         1	30			1	10
         2	55			2	17
         3	75			3	22
         4	90			4	26
         5	100			5	28
         6	105			6	29

         Food: Price=$20 each				Clothing: Price=$10 each
         Qty	Total Utility	Marginal Utility	MU/Price	Qty	Total Utility	Marginal Utility	MU/Price
         1	30	30	1.5	1	10	10	1
         2	55	25	1.25	2	17	7	0.7
         3	75	20	1	3	22	5	0.5
         4	90	15	0.75	4	26	4	0.4
         5	100	10	0.5	5	28	2	0.2
         6	105	5	0.25	6	29	1	0.1

         Suppose that income rises to $90?

         Suppose that the price of food rises to $30?

         Food: Price=$30 each				Clothing: Price=$10 each
         Qty	Total Utility	Marginal Utility	MU/Price	Qty	Total Utility	Marginal Utility	MU/Price
         1	30	30	1	1	10	10	1
         2	55	25	0.83	2	17	7	0.7
         3	75	20	0.66	3	22	5	0.5
         4	90	15	0.5	4	26	4	0.4
         5	100	10	0.33	5	28	2	0.2
         6	105	5	0.16	6	29	1	0.1

   3. Price Changes and Consumption Decisions
      1. Demand is the schedule of the amount of a product that consumers are willing and able to buy at various prices during a specific period.
      2. The first law of demand states that price and quantity demanded are inversely related.
      3. Price changes involve income and substitution effects.
         1. Substitution effect--As a good becomes relatively cheaper (more expensive) it becomes more attractive (less attractive) to consumers and quantity demanded rises (falls).

            Example: As the price of hamburgers falls, I find them cheaper (relative to other foods). As a consequence, I am likely to increase consumption of hamburgers. (Substitution effect).

         2. Income effect--As the price of a good falls (rises) consumers have greater (lower) consumption possibilities. Consequently, demand for all goods rises (falls).

            Example: As the price of hamburgers falls, as a consumer of hamburgers, I suddenly have more change leftover to spend not just on hamburgers, but other goods as well. As a consequence, I am likely to increase consumption of hamburgers. (Income effect).

   4. Time and Consumer Choice
      1. Time, like money, is scarce. A lower time cost (more convenience) will make a product more attractive to consumers.
      2. The explicit price (money price) is not always a complete measure of its cost to the consumer.
   5. Consumer Choice (Demand) and Market Demand
      1. The Market Demand schedule is the amount demanded by all individuals in the market. Just add all of the individual demand schedules together to get market demand.
      2. Since individuals purchase less as price rises, the quantity demanded by the market will fall as price rises.
   6. Consumer Surplus
      1. Consumer Surplus is a measure of the gain that buyers get from consuming a good.
      2. The amount of consumer surplus is determined by the market price. It is measured as the difference between the market price and the price the consumer would be willing and able to pay for various amounts of the good.
   7. What Causes Demand to Shift?
      1. Changes in Income
      2. Changes in the Distribution of Income Affects demand for different products
      3. Changes in the prices of closely related goods
         1. Complements
         2. Substitutes
      4. Changes in Consumer Preferences
2. The Elasticity of Demand
   1. Concept
      1. The Price Elasticity of Demand is the percentage change in the quantity of a product demanded divided by the percentage change in price.
      2. Price Elasticity of Demand refers to the flexibility of consumers' desire for the product. It shows how responsive consumer is to price changes.

         Arc elasticity is a useful way to estimate elasticities when prices and quantities change. It uses the midpoints of quantity and price to compute their respective percentage changes.

         Definitions:

         Demand is Price Elastic when: nd >1 ;

         Demand is Price Inelastic when: nd<1 ;

         Demand is Unitary Elastic when: nd=1

   2. Determinants of Elasticity of Demand
      1. The availability of substitutes--the more available, the more elastic demand will be.
      2. The share of total budget--the greater the share of total budget, the more elastic demand will tend to be. People tend to shop more for costly items.
      3. Time--The more time people have to adjust, the more elastic demand will become. Basically, given time, people can and do find more substitutes.
   3. Elasticity and Total Expenditures
      1. Price varies directly with total expenditures when demand is inelastic.
      2. Price varies inversely with total expenditures when demand is elastic.
   4. Using the Concept of Elasticity - The Burden of a Tax
      1. When demand is more elastic, buyers bear less of the tax burden.
      2. When supply is more elastic, sellers bear less of the tax burden.
      3. When either demand or supply is highly elastic, more trades are squeezed out and the deadweight burden of a tax is greater.

         True or False:

         A 10 percent reduction in price that leads to a 15 percent increase in the amount purchased indicates a price elasticity of demand greater than 1.

         A 10 percent reduction in price that leads to a 2 percent increase in total expenditures indicates a price elasticity of demand greater than 1.

         If the percent change in price is less than the resultant percent change in quantity demanded, demand is elastic.

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This page was last modified Monday, January 27, 1997.