Consumer Choice:

Individual and Market Demand

Everything is worth what its purchaser will pay for it.
PUBLILIUS SYRUS (1ST CENTURY b.c.)

Scarcity and Demand

Demand
Assumes that consumers
Can pay for the goods
Are willing to pay for the goods

Individual consumers choices

Constraint: income

Income scarce resource

Purchase decision interdependent

Utility
Theory of consumer choice
Hypothesis: each consumer spends income in
the way that yields the greatest amount of
satisfaction, or utility

Money utility
To analyze demand behavior

Purpose of utility analysis

How people behave
Not what people think
3

Utility
Total monetary utility
Of a quantity of a good to a consumer
Maximum amount of money
Willing to give up in exchange for it

Marginal utility
Of a commodity to a consumer
Maximum amount of money
Willing to pay for one more unit of the good

Addition to total utility

Table 1

Your Total and Marginal Utility for Pizza This Month

Utility
Law of diminishing marginal utility
The more of a good a consumer has
The less marginal utility an additional unit contributes
to overall satisfaction
If all other things remain unchanged

Additional units of a commodity

Are worth less and less to a consumer in money
terms

Utility
As a person acquires more of a commodity
Total utility increases
Marginal utility from that good decreases

Very scarce good

High marginal utility
Little total utility

Anomalies
Increasing marginal utility

Figure 1
Marginal Utility (Price) per Pizza

$16
A Marginal
A
Utility
(or Demand) Curve: Your
15
14
B
Demand
for
Pizza
C This Month
13
12
11
10
9
8
7
6
5
4
3
2
1

P
E

F
G
H
1

Number of Pizzas per Month

8

Utility
Marginal analysis
Method for calculating optimal choices
Choices that best promote the decision makers
objective

Testing whether, and by how much

A small change in a decision will move things toward
or away from the goal

Marginal Analysis
If marginal net utility is positive
Consumer must be buying too small a
quantity to maximize total net utility
Because marginal utility exceeds price
Consumer can increase total net utility further

by buying (at least) one more unit of the

product

If marginal net utility is negative

A buyer can get a higher total net utility by
cutting back the purchase quantity
10

Utility
Marginal net utility = MU - P
Marginal utility (MU) minus price (P)
If Positive
MU > P
(MU P) > 0
Total net utility uphill

If Negative
MU < P
(MU P) < 0
Total net utility downhill

11

Figure 2

Total Net Utility

Finding Your Optimal Pizza Purchase Quantity:

Maximizing Total Net Utility
$9
8
7
6
5
4
3
2
1
0
-1
-2

Total net
utility hill

Number of Pizzas

12

Utility
Optimal purchase rule
If MU > P
Buy more

If MU < P
Buy less

Maximize net total utility

MU = P
Marginal net utility = 0

13

Utility
Consumer that maximizes total net utility
Marginal utility schedule = Demand schedule
Marginal utility curve = Demand curve

Law of diminishing marginal utility

Demand curves
Slope downward to right
Negative slopes

14

Table 2

List of Optimal Quantities of Pizza for You to Purchase at Alternative Prices

15

Behavioral Economics
Are economic decisions really made
rationally?
Evidence
Behavior that is inconsistent with economists
typical rationality assumptions

Behavioral economics
Investigates how consumers and other
economic decision makers really behave
16

Behavioral Economics
Economically irrational behavior
People react in apparently irrational ways
Even though they may be fully aware that
their behavior is irrational

School cafeterias
Placement and presentation of particular
foods can influence what students choose
to eat

17

Behavioral Economics
Stock market investors
When prices are rising, they rush to invest
their money
Herd behavior: when many investors buy or
sell, others, like cattle, are sure to follow

18

How much does it really cost?

Real cost = opportunity cost of the
purchase
The commodities that we must give up as
a result of the purchase decision

Any decision to buy

Implies a trade-off because scarcity
constrains all economic decisions

19

Consumer Choice as a Trade-off

True cost of any purchase
Opportunity cost

Consumer surplus
Net gain from purchase
What consumers are willing to pay minus what
consumers actually pay
= Total utility (in money terms) Total
expenditures

Consumers: maximize consumer surplus

20

Consumer Choice as a Trade-off

Consumer surplus graphically
Demand curve - set of bars
Heights - marginal utilities

Horizontal line price

Consumer surplus area
Below demand
Above price

21

Table 3

Calculating Marginal Net Utility (Marginal Consumers Surplus) from Your Pizza Purchases

22

Figure 3
Marginal Utility and Price per Pizza

Graphic Calculation of Consumers Surplus

$16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0

$15.00 A

Marginal utility (demand) curve

$4.00 $13.00 B
$12.50 C
$2.00
$1.50 $11.50 D
$0.50

$8.00 E

$5.00 F
$3.00 G
$0

Number of Pizzas Purchased per Month

23

Consumer Choice as a Trade-off

Inferior good
Quantity demanded falls
When real income increases
All other things equal

Normal good
Quantity demanded increases
When real income increases
All other things equal

24

Market Demand Curves

Individual demand curve
From consumer choice

Market demand curve

How total quantity demanded
All consumers in the market
Specified period of time

Changes as price changes

All other things constant

Horizontal sum of the demand curves of

individual buyers
25

Figure 4

The Relationship between Total Market Demand and the Demand of

Individual Consumers within That Market

$10 A

Naomis
demand

C
9

Z
0

Market demand
K

D
0

M
Price

Z
Price

Price

Alexs
demand

M
15

Quantity demanded

Quantity demanded

Quantity demanded

(a)

(b)

(c)
26

Market Demand Curves

Law of demand
A lower price
Increases the amount of a commodity that people in
a market are willing to buy
Increases the number of buyers

Market demand curves

Negative slopes

27

Market Demand Curves

Exceptions to law of demand
When people judge quality on the basis of price
Perceive a more expensive commodity as offering
better quality

Snob appeal
To advertise ones wealth

28

ixIndifference curve analysis

d
n
e
p
p
A
Budget line for a household
All possible combinations
Of two commodities it can purchase

Given
Prices of commodities
Fixed amount of money

Choices available to consumer

29

Table 4

Alternative Purchase Combinations for a $12 Budget

30

Figure 5
7

Pounds of cheese

A Budget Line
A
6
5

4
C

3
K

E
0

Boxes of rubber bands

31

ixIndifference curve analysis

d
n
e
p
p
A
Properties of budget line
Points on budget line
Maximum amount of goods

Points below
Spend < budget

Points above
Not available

32

ixIndifference curve analysis

d
n
e
p
p
A
Changes in budget line
Income increase
Parallel shift

Price of one commodity decrease

Outward move

33

Figure 6
U

The8Effect of Income Changes on the

7
Budget
Line
A

Pounds of cheese

6
5

Income = $18

Income = $12

Income = $9

2
1
N
0

E
4

Boxes of rubber bands

34

Figure 7

Pounds of cheese

The7 Effect of Income Changes on the

A Line
Budget
6
5
Rubber band
price = $3.00

4
3

Rubber band
price = $1.50

2
1

E
0

H
5

Boxes of rubber bands

35

ixIndifference curve analysis

d
n
e
p
p
A
Consumer preferences
Indifference curves

Indifference curve
All combinations of commodities
Equally desirable consumer
Total utility

Higher indifference curve

Higher total utility
36

Figure 8

Pounds of cheese

7
Three Indifference
Curves for Cheese and
Rubber 6Bands
5

4
T

3
2

Ic

W
0

Ia
5

Ib
6

Boxes of rubber bands

37

ixIndifference curve analysis

d
n
e
p
p
A
Properties of indifference curves
Higher indifference curve
Higher total utility
Every point higher indifference curve
Preferred to any point on lower indifference curve

Never intersect
Negative slope
Round toward the axes
Bowed in
38

ixIndifference curve analysis

d
n
e
p
p
A
Slope of indifference curve
Marginal rate of substitution (MRS)
Between commodities

Maximum amount of one commodity

Consumer - willing to give up
For one more unit of another commodity

39

ixIndifference curve analysis

d
n
e
p
p
A
Slope of budget line
Amount of one commodity
Market allows
Consumer give up
For one more unit of another commodity

No change in budget
Ratio of prices

40

Figure 9
I

Pounds of cheese

Slopes of aMBudget Line and an

Indifference Curve
N

R
B

m
D
E

I
F

B
0

Boxes of rubber bands

41

ixIndifference curve analysis

d
n
e
p
p
A
The most desired combination of goods
Given budget
Point
Budget line
Tangent to indifference curve

Marginal rates of substitution

Equal: ratio of prices

42

Figure 10
Optimal 7Consumer
Choice
I
Pounds of cheese

Ia

Ib

4
T

3
2

W
0

Boxes of rubber bands

43

ixIndifference curve analysis

d
n
e
p
p
A
Increase in income
Budget line
Parallel outward shift

Buy more (both commodities)

Normal goods

Buy less (one commodity)

Inferior good

44

Figure 11
Pounds of cheese

Effects ofCa Rise in Income

OptimalWhen Neither
consumption
Good Is Inferior
B

curve

E
T
I2
I1
B
0

Boxes of rubber bands

45

Figure 12

Pounds of cheese

Optimal
Effects of a Rise
in
Income
When
Rubber
C
Consumption
Bands Are an Inferior
Good
Curve
B

B
0

Boxes of rubber bands

46

ixIndifference curve analysis

d
n
e
p
p
A
Consequences of price changes
Deriving the demand curve

Decrease in price of one commodity

Budget line moves outward
Quantity demanded rises
Demand curve negative slope
Other commodity
Change in quantity demanded

47

Figure 13
Consequences
of Price Changes
B
Pounds of cheese

3
4

C
0

Boxes of rubber bands

48

Figure 14
Price of rubber bands
per box

D
Deriving the Demand
Curve for Rubber
Bands
$4.00
t

1.50

D
0

Quantity of rubber bands

demanded (boxes)

49

Demand and Elasticity

A high cross elasticity of demand [between two
goods indicates that they] compete in the same
market. [This can prevent a supplier of one of the
products] from possessing monopoly power over
price.
U.S. SUPREME COURT, DUPONT
CELLOPHANE DECISION, 1956
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
50

Elasticity
Elasticity
Measure of responsiveness

Price Elasticity of demand

Ratio of percentage change in quantity
demanded to percentage change in price
That brings about the change in quantity
demanded

Responsiveness of quantity demanded to

price changes

51

Figure 1
Hypothetical Demand Curves for Film
Df

Ds
b

10

Df

1.5
Quantity demanded
(a)

Price per package

Price per package

$20

$20

10

Ds
0

Quantity demanded
(b)
52

Elasticity
Demand elastic
Elasticity > 1
A 10% rise in price
More than 10% drop in quantity demanded

Relatively flat demand curve

53

Elasticity
Demand inelastic
Elasticity < 1
10% rise in price
Less than 10% drop in quantity demanded

Relatively steep demand curve

54

Figure 2
The Sensitivity of Slope to Units of Measurement at
D
Pauls Pizza Parlor
$16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0

B
Price per Pizza

Price per Pizza

500 10001500 20002500 3000

280
360

Pizzas per week

(a)

$16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0

500 10001500 20002500 3000

2240 2880

Slices of Pizzas per week

(b)

55

Elasticity
Elasticity formula
Each change: percentage change
Each percentage change
Average values of the before and after quantities and
prices

Absolute value

Price elasticity of demand =

(Q1 Q0 ) / average of Q0 and Q1

(P1 P0 ) / average of P0 and P1

56

Elasticity
1. Perfectly elastic demand curve
Horizontal demand curve
Infinitely elastic

2. Perfectly inelastic demand curve

Vertical demand curve
Zero elasticity

57

Figure 3 (a), (b)

Demand Curves with Different Elasticities

Perfectly elastic
demand curve

$0.75

Perfectly
inelastic
demand
curve

Price

Price

D
0

0
Quantity demanded
(a)

90
Quantity demanded
(b)
58

Elasticity
3. Straight-lines demand curves
Slope constant
From left to right
Elasticity smaller

4. Unit-elastic demand curves

Elasticity = 1
10% rise in price
10% drop in quantity demanded

59

Figure 3 (c), (d)

Demand Curves with Different Elasticities
D
D
A

$6

$30

Price

Price

Straight-line
demand
curve

20

Unit-elastic
demand
curve

10
1

C
0

4 5

Quantity demanded
(c)

D
7

14

Quantity demanded
(d)
60

Table 1

Estimates of Price Elasticities

61

Total Revenue & Total Expenditure

Total revenue = PQ = Total expenditure
A point on a demand curve
Area of the rectangle under the point

Effects of a price decrease

Total revenue decreases because
Price decreases

Total revenue increases because

Quantity increases

62

Total Revenue & Total Expenditure

Increase in price
Demand is elastic
Total revenue will decrease

Demand is unit elastic

Total revenue will not change

Demand is inelastic
Total revenue will increase

63

Figure 4
An Elastic Demand Curve
D

Price

$6
5

S
V

4
3
2
1

T
0

12

Quantity demanded
64

What Determines Demand Elasticity?

1. Nature of the good
Necessities inelastic demand
Luxury goods elastic demand

2. Availability of close substitutes

Close substitutes: demand more elastic
No close substitutes: demand inelastic
Narrowly defined: more elastic

65

What Determines Demand Elasticity?

3. Share of consumers budget
Small inelastic demand
Large elastic demand

4. Passage of time
Short run inelastic demand
Long run elastic demand

66

Elasticity as a General Concept

Income elasticity of demand
Ratio of percentage change in quantity
demanded
To percentage change in income

Price elasticity of supply

Ratio of percentage change in quantity
supplied
To percentage change in price

67

Elasticity as a General Concept

Cross elasticity of demand for X to a
change in the price of Y
Ratio of percentage change in quantity
demanded of X
To percentage change in price of Y

Positive: Substitutes
Negative: Complements

68

Elasticity as a General Concept

Complements
An increase in the quantity consumed of
one good
Increases the quantity demanded of the
other good

Substitutes
An increase in the quantity consumed of
one good
Decreases the quantity demanded of the
other good
69

Time Period of Demand Curve

Demand curve
During a particular time period

An optimal decision
The one that best serves the objectives of the
decision maker
Selected by explicit or implicit comparison with
the possible alternative choices

70

Time Period of Demand Curve

Demand curve
Describes a set of hypothetical quantity
responses to a set of potential prices
But the firm can actually charge only one of
these prices

All of the points on the demand curve

Refer to alternative possibilities for the
same time period
The period for which the decision is to be
made

71

Polaroid versus Kodak

1989, trial, U.S. district court
Judgment against Eastman-Kodak
Patent infringement of technology
designed by Polaroid

10-year period (1976-1986)

Amount of money Kodak owed Polaroid
Profit loss by Polaroid
Price elasticity of demand
Cross elasticity of demand
72

Polaroid versus Kodak

Price elasticity of demand
Sales increase (instant camera)
Fall in price
Kodaks good reputation
Rise in consumer confidence

After 1980
Sales of instant cameras - drop sharply
Price of conventional cameras - drop

73

Polaroid versus Kodak

Cross elasticity of demand
Instant cameras and conventional
cameras

Elasticity calculations
Polaroid claimed that Kodak was
obligated to pay $9 billion or more
Kodak claimed that it owed Polaroid
$450 million
74

How can we find a legitimate demand

curve from historical statistics?
Estimating demand curve statistically
Collect a set of figures
Prices
Quantities sold
Different periods

Plott points
Draw a line: demand curve

75

Table 2

Historical Data on Price and Quantity

76

Figure 5
T

$8.20

May

Average Price

Plot8.00
of HistoricalFeb.
Data on Price and
R
April
Quantity
7.80
S

March

7.60
7.40
7.20

Jan.
T

7.00
0

90

91

92

93

94

95

96

97

98

Quantity Demanded in thousands

77

How can we find a legitimate demand curve

from historical statistics?

Problems
Different periods of time
Actual sales figures
Actual demand curve
May have shifted

78

Figure 6
T

$8.20

F
Plot of Historical
Data and True Demand
Feb.
8.00
R
Curves for January,
February,
and March
W
Average Price

7.80

7.60

March

M
F

7.40

7.20

Jan.
T

7.00
0

90

91
92
93 94
95
96
Quantity Demanded in thousands

97

98
79

Illustration: Did the Advertising Program Work?

Historical data - Relationship

Quantity demanded always rose
As advertising rose

Too perfect

Advertising spending
Based on sales

80

How can we find a legitimate demand curve

from the statistics?

Demand for umbrellas

Price changes
Movement along

Amount of rainfall changes

Shift of demand

Data
Demand curve no change
Supply curve shifted

81

Table 3

Rainfall in St. Louis for the period 20012009

82

Figure 7
Legitimate Demand Curve Estimation from
Statistical Data

83