Chapter Five The Demand Curve and the Behavior

Chapter Five The Demand Curve and the Behavior of Consumers

The Demand Curve and the Behavior of Consumers • Need to determine exactly what determines the slope and position of the demand curve • Also need to examine the behavior of consumers to see how well a market economy actually works Copyright © by Houghton Mifflin Company, Inc. All rights reserved 2

Figure 5. 1: A Typical Demand Curve Copyright © by Houghton Mifflin Company, Inc.

Utility and Consumer Preferences • Utility is a numerical indicator of a person’s preference for some goods compared to others. • If activity A is preferred to activity B, then the utility from A is greater than the utility from B. • Be careful not to confuse utility with “usefulness”. Utility describes enjoyment rather than tangible benefit. Example: TV watching vs. Studying Copyright © by Houghton Mifflin Company, Inc. All rights reserved 4

Figure 5. 2: Example of Utility from Grapes and Bananas Copyright © by Houghton

A Consumer’s Utility Depends on the Consumption of Goods • Looking at the table, note that a consumer gets more utility from 2 pounds of grapes and 1 pound of bananas (20) than from 1 pound of grapes and 1 pound of bananas (16). The addition of 1 pound of grapes increases utility by 4, which is called marginal utility. • Marginal utility is the increase in utility from consuming an additional unit of a good. Copyright © by Houghton Mifflin Company, Inc. All rights reserved 6

Utility Indicates Preference • We can rank utilities since it is a numerical value. However, in some cases there are ties. We say the consumer is indifferent as to the two situations. • Of all possible combinations, the one with the highest (maximum) utility is the one that is preferred to all the others. • Consumers maximize utility by making decisions that lead to the most preferred outcome from the viewpoint of the consumer. Copyright © by Houghton Mifflin Company, Inc. All rights reserved 7

Utility Indicates Preference • It doesn’t matter what units are used to measure utility. • Important to note: Can NOT compare one person’s utility to another’s. Can only compare one person’s utility for a particular good with the consumer’s utility for another good. Copyright © by Houghton Mifflin Company, Inc. All rights reserved 8

Budget Constraint and Utility Maximization • Budget Constraint: Income limitation on a person’s expenditure on goods and services –Depends on price of goods and services –In general, a higher price for a good reduces consumption opportunities for the individual Copyright © by Houghton Mifflin Company, Inc. All rights reserved 9

Figure 5. 3: The Budget Constraint ($8) and Expenditure at Two Different Prices Copyright

Maximizing Utility Subject to the Budget Constraint • Utility Maximization: The assumption that people try to achieve the highest level of utility given their budget constraint • Changes when price changes (shifts ALONG the demand curve) Copyright © by Houghton Mifflin Company, Inc. All rights reserved 11

Figure 5. 4: Maximizing Utility Subject to the Budget Constraint at Two Different Prices

Change in Income (Shift in the demand curve) • When an individual’s income is reduced, they aren’t able to buy as many goods. • When income decreases, the ENTIRE demand curve shifts left. • When income increases, the ENTIRE demand curve shifts right. • Income Effect: The amount by which the quantity demanded falls because of the decline in real income from a price increase Copyright © by Houghton Mifflin Company, Inc. All rights reserved 13

Figure 5. 5: Income Effect – New Budget Constraint of $6 Copyright © by

Substitution Effect • Substitution Effect: The amount by which quantity demanded falls when the price rises, exclusive of the income effect. – In English: If the cost of grapes goes up but other goods do not, grapes are RELATIVELY more expensive. People will switch their purchases to things other than grapes. Copyright © by Houghton Mifflin Company, Inc. All rights reserved 15

Income and Substitution Effects Quantity of Grapes Quantity of Bananas Original Quantity Demanded ($8 Budget Constraint and $1 per pound) 4 4 Budget Constraint becomes $6 3 3 Income Effect Price of Grapes Doubled (Budget Constraint is $8) 2 4 Substitution Effect Copyright © by Houghton Mifflin Company, Inc. All rights reserved Type of Effect 16

Measuring Willingness to Pay and Marginal Benefits • Marginal Benefit: The increase in the benefit from, or the willingness to pay for, one more unit of a good. • Diminishing Marginal Benefits: Marginal benefit decreases as quantity increases Copyright © by Houghton Mifflin Company, Inc. All rights reserved Quantity Willingness to pay for x Marginal Benefit 0 0. 00 _____ 1 5. 00 2 8. 00 3 9. 50 1. 50 4 10. 50 1. 00 5 11. 00 . 50 17

Figure 5. 6: Derivation of the Individual Demand Curve (Using Table 5. 1 on p. 114): Consumers only buy when PRICE = MARGINAL BENEFIT Copyright © by Houghton Mifflin Company, Inc. All rights reserved 18

Figure 5. 7: A Smooth Individual Demand Curve (Connecting the dots derived from marginal

Figure 5. 8: Derivation of the Market Demand Curve (Sum of Individual Market Demand

Consumer Surplus • Consumer Surplus: The difference between what a person is willing to pay for an additional unit of a good and the market price of the good. It is the area below the market demand curve and above the market price. Copyright © by Houghton Mifflin Company, Inc. All rights reserved 21