D2
to Q2.
Q2
Q
Qe
1
Q/ut
Figure III.A.10
8.3.2.1 SHIFT OF SUPPLY
R emember that the supply function was expressed,
Qxs = fs (Px, Pinputs, Tech, regulations, # sellers, . . . #S),
A change in the price of the good changes the quantity supplied. A change
in any of the other variables will shift the supply function. An increase in
supply can be visualized as a shift to the right, at each price a larger quantity
is produced and offered for sale. A decrease in supply is a shift to the left: at
each possible price a smaller quantity is offered for sale. If the supply shifts
and demand remains constant, the equilibrium price and quantity will be
altered.
An increase in supply (while demand is constant) will cause the equilibrium
price to decrease and the equilibrium quantity to increase. A decrease in
supply will result in an increase is the equilibrium price and a decrease in
equilibrium quantity.
165
8.3.2 Shifts or Changes in Demand
rice
S2
S
Given the demand (D) and the supply (S),
P
the equilibrium price in the market is Pe,.
S1
The equilibrium quantity is Qe.
An increase in supply is represented by a
P2
shift of supply from S to S1. This will cause
Pe
and decrease in equilibrium price from Pe to
P
P1 and an increase in equilibrium quantity
1
from Qe to Q1.
A decrease in supply to S2 will cause
equilibrium price to increase to P2 and
D
equilibrium quantity to fall to Q2.
Q2
Q
Qe
1
Q/ut
Figure III.A.11
8.3.2.2 CHANGES IN BOTH SUPPLY AND DEMAND
W hen supply and demand both change, the direction of the change of
either equilibrium price or quantity can be known but the effect on the other is
indeterminate. An increase in supply will push the market price down and
quantity up while an increase in demand will push both market price and
quantity up. The effect on quantity of an increase in both supply and demand
will increase the equilibrium quantity while the effect on price is dependent on
the magnitude of the shifts and relative structure (slopes) of supply and
demand. The effect of an increase in both supply and demand is shown in
Figure III.A.12.
Given supply (S) and demand (D), the
equilibrium price is Pe and quantity is Qe.
rice P
S
An increase in supply to S1 results in a drop in
S1
price from Pe to P1 while quantity increases from
Qe to Q1.
P2
Pe
If demand then increased to D1, the equilibrium
quantity would increase to Q*. The price
P1
however, is pushed up. In this case the price is
returned to Pe. If the shift in demand were
D1
greater of less (or the slopes of S and D) were
different, the equilibrium price might rise, fall or
D
166remain the same; the change is indeterminate
Q
’
e
Q1
Q*
Q/ut
until we have more information.
Figure III.A.12
8.3.2 Shifts or Changes in Demand
When supply and demand both shift, the direction of change in either
equilibrium price or quantity can be known but direction of change in the value
of the other is indeterminate.
8.3.3 EQUILIBRIUM AND THE MARKET
W hether equilibrium is a stable condition from which there “is no
endogenous tendency to change,” or and outcome which the “economic
process is tending toward,” equilibrium represents a coordination of objectives
among buyers and sellers. The demand function represents a set of
equilibrium conditions of buyers given the incomes, relative prices and
preferences. Each individual buyer acts to maximize his or her utility, ceteris
paribus. The supply function represents a set of equilibrium conditions given
the objectives of sellers, the prices of inputs, prices of outputs, technology,
the production function and other factors.
The condition of equilibrium in a market, where supply and demand
functions intersect (“quantity supplied is equal to the quantity demanded”)
implies equilibrium conditions for both buyers and sellers.
167
9 Demand and Consumer Behavior
9 DEMAND AND CONSUMER BEHAVIOR
D emand is a model of consumer behavior. It attempts to identify the
factors that influence the choices that are made by consumer. In Neoclassical
microeconomics, the objective of the consumer is to maximize the utility that
can be derive given their preferences, income, the prices of related goods and
the price of the good for which the demand function is derived. An individual’s
demand function can be thought of as a series of equilibrium or optimal
conditions that result as the price of a good changes. There are two
approaches that may be used to explain an individual’s demand function:
utility analysis and indifference analysis. The two approaches are compatible.
9.1 CONSUMER CHOICE AND UTILITY
U tility is the capacity of a good (or service) to satisfy a want. It is one
approach explain the phenomenon of value. Utilitarianism is the ethical
foundation of Neoclassical microeconomics. Jeremy Bentham [1748-1832]
formalized “utilitarianism.” Utility is a subject evaluation of value. Bentham
seemed to intuitively grasp the notions of total an marginal or incremental
utility. However, it was not until 1844 that Dupuit [1804-1866] linked marginal
utility to the concept of demand. Heinrich Gossen [1810-1858] developed the
“law of satiable wants” which is considered to be a forerunner of the “law of
diminishing marginal utility. In 1871 William Stanley Jevons [1835-1882] used
the term “final degree of utility” and Carl Menger [1840-1921] recognized that
individuals rank order their preferences. It was Friedrich von Wieser, [1851-1926] who first used the term “marginal utility.”
9.1.1 UTILITY
168
9.1.1 Utility
S ince utility is subjective and cannot be observed and measured directly,
it use here is for purposes of illustration. The objective in microeconomics is to
maximize the satisfaction or utility of individuals given their preferences,
incomes and the prices of goods they buy.
A. TOTAL UTILITY (TU) AND MARGINAL UTILITY (MU)
Total utility (TU) is defined as the amount of satisfaction or utility that one
derives from a given quantity of a good. Marginal utility (MU) is defined as
the change in total utility that can be attributed to a change in the quantity
consumed.
Total Utility = TU = f ( Q, preferences, …)
ΔTU
Marginal Utility = MU = ΔQ
As a larger quantity of a good is consumed in a given period we expect that
the TU will increase at a decreasing rate. It may eventually reach a maximum
and then decline. Remember the last time you went to an all you can eat pizza
place and ate too much? This is shown in Figure IV.A.1. As the quantity of
pizza/day consumed increases, the TU derived from the pizza increases at a
decreasing rate until the maximum or 27 is reached at the 5th pizza.
169
9.1.1 Utility
TU is a function of the individual’s
TUP
preferences and the quantity consumed. In
the illustration to the right, 10 units of utility
27
are obtained by consuming 1pizza/day. The
26
consumption of 2 pizzas/day results in a
TUP
24
total of 18 units of satisfaction. The
maximum satisfaction that can be derived
18
from the consumption of pizza is 27. This
occurs at 5 pizzas. If the individual eats
more than 5 pizzas their total satisfaction
declines.
10
1
2
3
4
5
Pizza/day
Figure IV.A.1
Total Utility can be displayed in table form. The information contained in
Figure IV.A.1 is shown in Table IV.1
Marginal utility (MU) is the change in TU that is “caused” by a change in the
quantity consumed in the particular period of time. MU was defined:
Δ TU
MU = ΔQ
TABLE IV.1
TOTAL & MARGINAL
In Table IV.1 marginal utility is calculated by subtraction. The change in
UTILITY
quantity from row to row is 1 (∆Q = 1). Therefore
Qu
a th
nt e change in total utility
TU
MU
can be calculated be subtracting the TU associate
i d
ty with each quantity from
that associated with the next quantity. In Table I
0 V.1 the to
0 tal utility (T
-- U)
1
10
10
derived from 1 unit of the good is 10. The TU derived from 2 units is 18: ∴ the
2
18
8
change in total utility (∆TU) attributable to a one unit change in quantity (∆Q)
3
24
6
is 8.
4
26
2
5
27
1
6
26
-1
170
9.1.1 Utility
Δ TU
8
MU =
=
= 8
ΔQ
1
The MU of the third unit is 6
[
ΔTU
24 − 18
6
MU =
=
=
= 6
3
]
ΔQ
1
1
When the MU is calculated by subtraction, it can be visualized as the slope of
the TU between two points. This is shown in Figure IV.A.2
The MU can be visualized as the slope of the
TUP
∆ TU
TU between successive units of the good. In
MU =
the graph to the right the MU of the third unit
27
∆ Q
of Pizza is the slope of the TU between points
26
TUP
A and B.
24
B
Think of the slope of a line as rise over run.
∆ TU
18
∆ TU rise and ∆ Q is the run. In this example
A
the ∆ Q is 1 ( from the third to the fourth unit
is 1). The ∆ TU is 6 (24-18). ∴ rise over run
10
∆ Q
or the slope of TU between points A and B is
6.
1
2
3
4
5
Pizza/day
Figure IV.A.2
Marginal utility can be graphed, however remember that the MU calculated by
subtraction is “between” successive units of the good. It is the slope of an arc
defined by two points on a total utility function. This is shown in Figure IV.A.3
171
9.1.1 Utility
In the graph to the right, one unit of the good
TU
yields 18 units of satisfaction while 2 units
G’
of the good result in 30 units of satisfaction.
40
Marginal Utility (
ΔTU
MU =
) can be shown
35
ΔQ
as the slope of a line from point R to B. this
30
R
is the red “arc” between the two points. The
25
12
actual TU is shown by the curved blue line
=
20 G
rise
U
between R and B.
rise
ΔTU
12
B
MU =
=
=
= slope of TU
15
∆T
run
ΔQ
1
run
10
∆ Q =1
MU can be calculated as a derivative. At 2
units of the good the MU will be the slope
5
of the line GG’ tangent to TU at point B.
1
2
3
Q/ut
Figure IV.A.3
The relationship between total utility (TU), marginal utility (MU) and average
utility can be shown graphically. In Figure IV.A.4 the TU function has some
peculiar characteristics so all-possible circumstances can be shown. In this
example the total utility (TU) first increases at an increasing rate. Each
additional unit of the good consumed up to the Q* amount causes larger and
larger increases in TU. The MU will rise in this range. At Q* amount there is an
inflection point in TU. This is consistent with the maximum of the MU. When
AU is is a maximum, MU = AU. When TU is a maximum, MU is 0. This is shown
in Figure IV.A.4
172
9.1.1 Utility
TU
TU
In the graph to the right, TU increases at an
increasing rate from 0 to Q* units of the good. At
Q* there is an inflection point in TU. This is
consistent with the maximum of the MU. Beyond
Q/ut
Q* amount the TU increases at a decreasing rate.
MU (the slope of TU) decreases. Q* is the “point of
MU
diminishing MU.”
AU
When MU > AU, AU is “pulled up.” When MU <
AU, AU is “pulled down.” When MU = AU, AU is
a maximum. (AU is unchanged, its slope is 0, ∴ AU
is a maximum)
At QM the TU is a maximum. At this output the
slope of TU is 0. MU is the slope of TU ∴ MU = 0.
AU
Q* Q
Q
Q/ut
M MU
Figure IV.A.4
B. DIMINISHING MARGINAL UTILITY
It is believed that as an individual consumes more and more of a given
commodity during a given period of time, eventually each additional unit
consumed will increase TU by a smaller increment, MU decreases. This is
called “diminishing marginal utility.” As a person consumes larger quantities of
a good in a given time period, additional units have less “value.” Adam Smith
recognized this phenomenon when he posed this “diamond-water paradox.”
Water has more utility than diamonds. However, since water is plentiful, its
marginal value and hence its price is lower than the price of diamonds that are
relatively scarce.
173
9.1.1 Utility
C. BUDGET CONSTRAINT
When goods are “free,” an individual should consume until the MU of a good is
0. This will insure that total utility is maximized. When goods are priced above
zero and there is a finite budget, the utility derived from each expenditure
must be maximized.
An individual will purchase a good when the utility derived from a unit of the
good X (MUX) is greater than the utility derived from the money used to
purchase the good (MU$). Let the price of a good (PX) represent the MU of
money and the MUX represent the marginal benefit (MBX) of a purchase. When
the PX > MBX, the individual should buy the good. If the PX < MBX, they should
not buy the good. Where PX = MBX, they are in equilibrium, they should not
change their purchases.
Given a finite budget (B) and a set of prices of the goods (PX , PY, PN) that are
to be purchased, a finite quantity of goods (QX, QY, QN) can be purchased. The
budget constraint can be expressed,
B ≥ P Q + P Q +… + P Q
X
X
Y
Y
N
N
Where B = budget
P = price of N th good
N
Q = quantity of N th good
N
For one good the maximum amount that can be purchased is determined by
the budget and the price of the good. If the budget were 80€ and the price
was 5€, it would be possible to buy 16 units. The amount that can be
purchased is the budget (B) divided by the price of the good (PX).
Budget
B
Q that can be purchased =
=
X
Price
P X
The combinations of two goods that can be purchased can be shown
graphically. The maximum of good X that can be purchased is .
174
9.1.1 Utility
B
B
, the amount of good Y is
P
P
X
Y
All possible combinations of good X and Y that can be purchased lie along (and
inside) a line connecting the X and Y intercepts. This is shown in Figure IV.A.5
In the graph to the right, the budget is 80€.
QY
When the price of good Y (PY) is 4€, a maximum of
20 units of good Y can be purchased. This is shown as
Budget constraint when B =
point A on the Y-axis. If the price of good X is 5€, a
80€,
maximum of 16 units of X can be purchased.
PX = 5€
This is point H on the X-axis. The line AH
B
80
A
PY = 4€
=
= 20
represents the maximum combinations of goods
4
Y
P
X and Y that can be bought given the budget and
prices. Any combination of goods that lies in the
triangle OAH (yellow area) can be purchased.
An increase in the budget will “shift” the budget
constraint out. A decrease in the budget will shift
it in.
A change in the relative prices will “rotate” the
constraint (change its slope).
H
O
B
80
Q
=
= 16
X
5
X
P
Figure IV.A.5
In order to maximize the utility derived from the two goods, the individual
must allocate their budget to the “highest valued use.” This is accomplished by
the use of marginal analysis. There are two steps to this process. First, the
marginal utility of each unit of each good is considered. Second, the price of
each good (or the relative prices) must be taken into account.
It is believed that as a person consumes more and more of a
(homogeneous) good in a given period of time, that eventually the total utility
(TU) derived from that good will increase at a decreasing rate: the point of
diminishing marginal utility (MU) will be reached.
175
9.1.1 Utility
When there are two (or more) goods (with prices) and a budget, the individual
will maximize TU by spending each additional dollar (euro, franc, pound or
whatever monetary unit) on the good with th