Consumer Demand

OVERVIEW

Utility Theory Indifference Curves Budget Constraints Individual Demand Demand Curves and Consumer Surplus Consumer Choice Optimal Consumption

KEY CONCEPTS

utility nonsatiation principle indifference ordinal utility cardinal utility utility function utils market baskets marginal utility law of diminishing marginal utility indifference curves substitutes complements perfect substitutes perfect complements

budget constraint income effect substitution effect price-consumption curve income-consumption curve Engle curve normal goods inferior goods consumer surplus two-part pricing bundle pricing optimal market basket revealed preference marginal rate of substitution consumption path

Utility Theory

Assumptions About Consumer Preferences

Utility Functions

More is better. Consumers can rank preferences. Consumers ran-order desirability of products. Descriptive statement relates well-being and consumption.
Added benefit is focus of consumers.

Marginal Utility

Law of Diminishing Marginal Utility

Marginal utility eventually declines for everything.

Indifference Curves

Basic Characteristics of Indifference Curves

Higher indifference curves are better. Indifference curves do not intersect. Indifference curves slope downward. Indifference curves are concave to origin.

Perfect Substitutes and Perfect Complements

Perfect substitutes satisfy the same need. Perfect complements are consumed together.

Budget Constraints

Basic Characteristics of Budget Constraints

Shows affordable combinations of X and Y. Slope of PX/PY reflects relative prices.

Effects of Changing Income and Changing Prices

Budget increase causes parallel outward shift. Budget decrease causes parallel inward shift. Income (substitution) effect is change in overall (relative) consumption.

Income and Substitution Effects

Individual Demand

Price-consumption Curve

Shows how consumption is affected by price changes (movement along demand curve). Shows how consumption is affected by income changes (shifts from one demand curve to another).
Plot between income and quantity consumed.

Income-consumption Curve

Engle Curves

Consumption of normal goods rises with income. Consumption of inferior goods falls with income (rare).

Demand Curves and Consumer Surplus

Graphing the Demand Curve

Demand curves always slope downward.

Value received above amount paid.

Consumer Surplus

Consumer Surplus and Two-Part Pricing: An Illustration

Membership fees and user fees extract consumer surplus for the seller. Bundle pricing extracts consumer surplus for sellers.

Consumer Surplus and Bundle Pricing

Consumer Choice

Marginal Utility and Consumer Choice

Optimal consumption maximizes utility. Optimal consumption reflects marginal utility (benefits) and marginal costs.
Documented desire. Buyer decisions can be used to infer consumer preferences.

Revealed Preference

Optimal Consumption

Marginal Rate of Substitution (MRS)

MRSXY = -MUX/MUY and equals indifference curve slope. MRSXY shows tradeoff in the amount of X and Y consumed, holding utility constant. MRSXY diminishes as amount of substitution of X for Y increases.
Optimality requires PX/PY = MUX/MUY. Optimality requires MUX/PX = MUY/PY.

Utility Maximization