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. All rights reserved 3
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 Mifflin Company, Inc. All rights reserved 5
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 © by Houghton Mifflin Company, Inc. All rights reserved 10
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 Copyright © by Houghton Mifflin Company, Inc. All rights reserved 12
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 Houghton Mifflin Company, Inc. All rights reserved 14
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 benefit) Copyright © by Houghton Mifflin Company, Inc. All rights reserved 19
Figure 5. 8: Derivation of the Market Demand Curve (Sum of Individual Market Demand Curves) Copyright © by Houghton Mifflin Company, Inc. All rights reserved 20
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
Figure 5. 9: Consumer Surplus for an Individual Copyright © by Houghton Mifflin Company, Inc. All rights reserved 22
Figure 5. 10: Consumer Surplus for the Market Copyright © by Houghton Mifflin Company, Inc. All rights reserved 23
Figure 5 A. 1: Budget Line for a Consumer Copyright © by Houghton Mifflin Company, Inc. All rights reserved 24
Figure 5 A. 2: Effect of a Change in Income on the Budget Line Copyright © by Houghton Mifflin Company, Inc. All rights reserved 25
Figure 5 A. 3: Effect of a Higher Price of X on the Budget Line Copyright © by Houghton Mifflin Company, Inc. All rights reserved 26
Figure 5 A. 4: An Indifference Curve for a Consumer Copyright © by Houghton Mifflin Company, Inc. All rights reserved 27
Figure 5 A. 5: Higher and Lower Indifference Curves Copyright © by Houghton Mifflin Company, Inc. All rights reserved 28
Figure 5 A. 6: The Best Choice for the Consumer Copyright © by Houghton Mifflin Company, Inc. All rights reserved 29
Figure 5 A. 7: An Increase in the Price of X Copyright © by Houghton Mifflin Company, Inc. All rights reserved 30
Figure 5 A. 7: An Increase in the Price of X (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved 31
Figure 5 A. 8: A Decrease in Income Copyright © by Houghton Mifflin Company, Inc. All rights reserved 32
Figure 5 A. 9: Illustration of Income Effect and Substitution Effect of a Price Change Copyright © by Houghton Mifflin Company, Inc. All rights reserved 33
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