Transcript 0405EC6L03CH03

HKALE Microeconomics

Chapter 3: Consumer Demand(1)-The
MUV Approach and Exchange
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
1
Six Basic Postulates
1. Each individual desires more goods
and has many goals.
2. For each individual, some goods are
scare.
3. Postulate of substitution: economic
goods are substitutable, i.e. each
person is willing to forsake some of a
good to get more of other goods.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
2
Six Basic Postulates
4. Postulate of diminishing MUV: the
more of a good one has, the larger
the TUV, but the lower the MUV of a
unit.
5. Not all individuals have identical tastes
and preferences.
6. Individuals are innovative but logically
consistent in making choice.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
3
Use Value and Exchange Value
 Value can be referred to use value or
exchange/market value.
 (Personal) use value (or value in use) of a
unit of a good is defined as the maximum
amount of another good which a person is
willing to forgo in order to obtain it.
 Exchange value (or value in exchange) is
defined as the amount of some other goods
or money that a consumer has to pay for a
given amount of a good in the market.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
4
Use Value Vs. Exchange Value
The use value of a good is the
maximum amount of other good one
is willing to give up for obtaining that
good.
The exchange value of a good is,
however, the amount of other good to
be exchanged within a transaction.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
5
Use Value Vs. Exchange Value
Use value is subjective.
However, exchange value is an
objective concept because it can be
measured, e.g. an apple can be
exchanged with two lemons in a
transaction.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
6
Use Value Vs. Exchange Value
The use value of a good depends on
how people evaluate the good(i.e.
individual preference) or is positively
related to the number of its uses.
However, the exchange value of a good
depends on the demand for and the
supply of the good, i.e. depending on
the degree of scarcity.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
7
Use Value Vs. Exchange Value
The use value of a good may be
measured by the amount of money one
is willing to sacrifice.
The exchange value of a good, however,
if measured in terms of money, is called
money price; if measured in terms of
other good, it is called relative price.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
8
Use Value Vs. Exchange Value
Paradox of value: the use value of a
good may not be in proportion to its
exchange rate.
Example: water has high use value but
low exchange value, while diamond has
low use value but high exchange value.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
9
Value Vs. Cost: Differences
Value is the max. amount of other good
one is willing to forgo for obtaining a
good.
Cost is the value of the highest-valued
option forgone in making a decision.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
10
Value Vs. Cost: Differences
Value is a reflection of an individual's
preference.
Cost, however, as an ex-ante concept, is
a constraint of behavior.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
11
Value Vs. Cost: Differences
The value of a free good may be
positive while the cost of a free good,
however, is zero.
Value arises when people make
personal valuation while cost arises
because of scarcity.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
12
Value Vs. Cost: Similarities
They are measured in terms of other
goods.
They are expressed in terms of
'maximum' amount of other good.
They can affect decision-making.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
13
Value Vs. Cost
Cost and value are not necessarily
related. In fact, cost and value are used
to derive the decision-making process
of individuals.
Example: a hair cut poorer than
anticipated only reduces its value, but it
does not raise its cost. The cost of the
hair cut will rise if the time involved in
getting it done, increases in value.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
14
Cost Vs. Price
Cost is the highest-valued option
forgone while price is the physical
exchange rate of one good for another
good.
Cost arises because of scarcity, no
choice hence results in no cost.
However, price arises because of
exchange, no exchange hence leads to
no price.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
15
Cost Vs. Price
Cost still exists in an one-man economy
while price is absent in one-man
economy because of no interpersonal
exchange.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
16
TUV, AUV & MUV



Total use value (TUV) is the maximum
total amount of another good that one is
willing to pay for the entire quantity of a
good.
Average use value (AUV) is the total use
value divided by the number of units (Q) of a
good, i.e. TUV/Q
Marginal use value (MUV) is the maximum
amount of another good that a person is
willing to pay for an extra unit of a good.
MUV=TUV/Q=slope of TUV curve.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
17
TUV, AUV & MUV: Illustration
Q(1)
MUV(2)
= (4)/ (1)
AUV(3)
=(4)/(1)
TUV(4)
=(2)
$10
$9
$8
$7
$6
$5
$4
$3
$2
$1
$10.0
$9.5
$9.0
$8.5
$8.0
$7.5
$7.0
$6.5
$6.0
$5.5
$10
$19
$27
$34
$40
$45
$49
$52
$54
$55
1
2
3
4
5
6
7
8
9
10
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
18
TUV, AUV & MUV: Diagrams
Use Value
TUV
MUV
AUV
0
By Mr. LAU san-fat
Q
CH3-Consumer's Demand(1)
19
The Marginal Use Value Curve



A MUV curve slopes downward indicating that
as one's holdings of a good get larger, there
is a decrease in one's marginal personal value
for that good.
The position or height of the whole curve
varies positively with the wealth (or number
of other goods) a person has: it shifts upward
for superior goods and downward for inferior
goods.
With different tastes or preferences, the MUV
curves are not identical for everyone.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
20
Price, MUV & Consumer's
Equilibrium




In making consumption, individuals will
compare its cost (P) with expected benefits
(MUV) of a good.
If MUV>P, it is beneficial to buy and thus
bringing down MUV until decreasing MUV=P.
If, however, MUV<P, one will reduce his
quantity demanded for avoiding loss, which
brings up MUV until increasing MUV=P.
Hence, consumer's equilibrium is attained
when P=MUV (for the last/marginal unit
transacted).
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
21
Demand Curve and MUV
Curve

A consumer's MUV curve of a good can
be regarded as an ordinary individual
demand curve for that good because:


given the MUV curve, one maximizes his
gain by equating his MUV with the market
price.
it tells how many units one consumes
given any level of market prices.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
22
Price, Total Revenue, Average
Revenue & Marginal Revenue


Total revenue, TR=PXQ
Average revenue




AR=TR/Q
Then, AR=(PXQ)/Q
Thus, AR=P
Marginal revenue, MR=TR/Q
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
23
Demand Curve & Average
Revenue (AR) Curve



Demand curve reflects relationship
between P & Qd while AR curve reflects
AR & Qd(=Qs=Qt at equilibrium).
As P=MUV and P=AR,
 P=AR=MUV
Hence, AR curve=D curve=MUV curve
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
24
P, TR, AR & MR: Illustration
P(1)
Q(2)
AR
=(3)/(2)
10
MR
=(3)/(2)
1
TR(3)
=(1)x(2)
10
10
9
8
7
2
3
4
18
24
28
9
8
7
8
6
4
6
5
4
5
6
7
30
30
28
6
5
4
2
0
-2
3
8
24
3
-4
2
1
9
10
18
10
2
1
-6
-8
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
10
25
TR, AR & MR: Diagrams
TR
TR
0
Q
AR, MR
0
By Mr. LAU san-fat
MR
AR
CH3-Consumer's Demand(1)
Q
26
TR, AR & MR: Diagrams
TR
TR reaches its maximum when MR=0.
TR
0
Q
AR, MR
0
By Mr. LAU san-fat
MR
AR
Q
CH3-Consumer's Demand(1)
27
TR, AR & MR: Diagrams
TR
TR reaches its maximum when MR=0.
TR
0
Q
AR, MR
0
By Mr. LAU san-fat
TR rises when MR is positive
MR
AR
Q
CH3-Consumer's Demand(1)
28
TR, AR & MR: Diagrams
TR
TR reaches its maximum when MR=0.
TR
0
Q
AR, MR
0
By Mr. LAU san-fat
TR falls when MR falls
TR rises when MR rises
MR
AR
Q
CH3-Consumer's Demand(1)
29
Finding TR from AR Curve

TR=rectangular area defined by
drawing perpendicular lines from a
particular price and the corresponding
quantity to the demand/AR curve.
P
AR
P1
0
By Mr. LAU san-fat
TR
Q1
CH3-Consumer's Demand(1)
Q
30
Finding TR from MR Curve

TR=the area under the MR curve and
above the quantity axis.
MR1 for 1st
unit sold
P, AR, MR
AR
P1
0 1 2 3 4 MR
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
Q
31
Finding TR from MR Curve

TR=the area under the MR curve and
above the quantity axis.
P, AR, MR
Summation of
MR for 4 units
sold
AR
P1
TR
0
By Mr. LAU san-fat
4 MR
CH3-Consumer's Demand(1)
Q
32
Finding MR from TR Curve

MR=slope of the TR curve=TR/ Q.
P, AR, MR, TR
Slope of TR curve = MR
TR1
E
TR
TR
0
Q1
Q
Q
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
33
Finding AR from TR curve

AR=TR/Q=slope of a ray from the
origin to a point on TR, say point E.
P, AR,MR, TR
TR1
Slope
of the
ray
= AR
A ray from the origin to point E
E
TR
TR at point E
0
Q1
Q at point E
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
Q
34
Why is Price Larger Than MR?



Because a cut in price is made to sell more
units, the extra revenue will be less than the
price received on the extra unit sold.
However, the new uniform price at which an
extra unit is sold is lower on ALL the units
formerly sold at the higher price.
Reduction in revenue on the quantity
previously sold at the higher price will offset
part of (or possibly more than) the price
received on the extra unit sold.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
35
Why is Price Larger Than MR?



Thus, the net revenue increase or MR from
selling one more at the new, lower price will
always be less than the price received on
that extra unit – less by the amount of
reduced revenue on all the units formerly
salable at the old, higher price.
With different pricing tactics, say price
discrimination, MR could be equal to P.
MR =P2(Q2-Q1)-(P1-P2)Q1
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
36
Relations Between TR, AR &
MR

MR is less than AR(or P)
P, AR, MR
P
Q
MR
10
1
10
9
2
8
Loss in TR
P1=$10
P2=$9
0
Gain in TR  MR from selling 2nd unit
D=AR
Q1 Q2
1 2
By Mr. LAU san-fat
Q
CH3-Consumer's Demand(1)
37
Relations Between TR, AR &
MR

MR is less than AR(or P)
P, AR, MR
Loss in TR
P1=$10
P2=$9
$8
0
D=AR
Q1 Q2
By Mr. LAU san-fat
MR
= P2(Q2-Q1)
-(P1-P2)Q1
P
Q
MR
10
1
10
9
2
8
Part of the TR from selling 2nd unit
will be taken away as a
compensation for loss in revenue of
the previous unit(s) under uniform
pricing.
MR of 2nd unit sold
CH3-Consumer's Demand(1)
Q
38
Relations Between TR, AR &
MR

MR is less than AR(or P): an illustration
P
Q
TR
AR
MR=P2(Q2-Q1)-(P1-P2)Q1
10
1
10
10
/
9
8
2
3
18
24
9
8
9(2-1)-(10-9)1=8
8(3-2)-(9-8)2=6
7
6
5
4
5
6
28
30
30
7
6
5
7(4-3)-(8-7)3=4
6(5-4)-(7-6)4=2
5(6-5)-(6-5)5=0
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
39
Relations Between TR, AR &
MR

The slope of MR curve is twice the slope
of AR curve.
P, AR, MR
B
P1
0
By Mr. LAU san-fat
Remarks:
Point A=mid-point of AR curve
Area BCP1=area ACQ1
C
A
D=AR
Q1 MR
CH3-Consumer's Demand(1)
40
TEV, AEV & MEV

(Total)Exchange value (TEV) of a
specified quantity of a good is the
actual amount of money(or some other
goods) that one has to pay for that
entire specific quantity.


TEV=PXQ
TEV=Total revenue(TR)=Total
expenditure(TE) =Total market value(TMV)
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
41
TEV, AEV & MEV



Average exchange value(AEV) of a specified
quantity of a good is the average revenue
received by the seller, i.e. AEV=AR=TEV/Q.
Marginal exchange value(MEV) is the actual
amount of money or some other goods one
pays for an extra unit of the good, i.e.
MEV=TEV/Q.
Under uniform pricing/single per-unit pricing
arrangement, price refers to AEV or AR.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
42
Consumer's Surplus (CS)

CS is the extra amount the consumer is
willing to pay over and above what he
or she actually pays, given quantity
demanded.



CS=TUV-TEV for a given quantity
CS=MUV-P for an extra unit
It is assumed that the CS is calculated
under uniform pricing (or single per-unit
pricing).
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
43
Consumer's Surplus (CS)
P, MUV
A
CS
P1
B
D=MUV
TEV
0
By Mr. LAU san-fat
Remarks:
•Area 0ABQ1=TUV
•Area 0P1BQ1=TEV
•CS=TUV-TEV
=area 0ABQ1-area 0P1BQ1
=area ABP1
Q
Q1
CH3-Consumer's Demand(1)
44
Consumer's Surplus (CS): An Illustration
P(1)
=MUV
10
Q(2)
TUV(4)
=(1)
1
TEV(3)
=(1)X(2)
10
10
CS(5)
=(4)-(3)
0
9
8
7
2
3
4
18
24
28
19
27
34
1
3
6
6
5
4
3
5
6
7
8
30
30
28
24
40
45
49
52
10
15
21
28
2
1
9
10
18
10
54
55
36
45
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
45
Paradox of Value

Adam Smith pointed out in his book,
'The Wealth of Nations', that the things
(e.g. water) which have the greatest
value in use frequently have little or no
value in exchange and those (e.g.
diamond) which have the greatest value
in exchange frequently have little value
in use.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
46
Resolving The Paradox of
Value




The paradox arises from confusing total and
marginal use values with market values.
The exchange value of a good is determined
by its relative scarcity and its MUV, but not its
TUV.
The more scarce the good, the higher its
MUV will be, thus demanding a higher
price(or average exchange value); vice versa.
While a good with higher TUV would bring a
larger consumer's surplus and thus more
benefit.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
47
Resolving The Paradox of
Value
Diamond
Water
P, MUV
S
P
S
CS
TEV
0
P, MUV
Q
By Mr. LAU san-fat
P
D=MUV
CS
D=MUV
TEV
Q
0
CH3-Consumer's Demand(1)
Q
Q
48
Ways to Extract Consumer's
Surplus(1)

By all-or-nothing pricing tactic



Consumers either purchase a good at a
stipulated quantity at a given price, or not
at all.
The price under an all-or-nothing
arrangement is set in accordance with the
AUV of the last unit, i.e. P=AUV.
As the TUV of the good becomes the same
as its TEV, CS is then fully exploited.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
49
Ways to Extract Consumer's
Surplus(1)

By all-or-nothing pricing (AONP) tactic
Remarks:
TEV=P2XQ2=area 0P2BQ2
TUV=area 0AEQ2
P, MUV, AUV
A
C
P2=AUV
All-or-nothing D=AUV
P1=MUV
0
B
E
Q1
By Mr. LAU san-fat
Q2
Ordinary D=MUV
CH3-Consumer's Demand(1)
Q
50
Ways to Extract Consumer's
Surplus(1)

By all-or-nothing pricing (AONP) tactic
P, MUV, AUV
A
C
P2=AUV
All-or-nothing D=AUV
P1=MUV
0
B
Remarks: Under uniform pricing,
consumer buys Q2 at P1(=MUV);
however, under AONP,he has to
pay P2(=AUV) for Q2, or not at all.
Thus, as area ACP2=area BCE,
TUV=TEV & CS=0.
E
Q1
By Mr. LAU san-fat
Q2
Ordinary D=MUV
CH3-Consumer's Demand(1)
Q
51
Ways to Extract Consumer's
Surplus(2)

By charging price with fees, e.g.
membership fees or license fees, where
the fee is set to extract all of the
consumer's surplus.
P, MUV
A
P1
0
Remark:
TEV=area 0P1EQ1
+ area P1AE
TUV=area 0AEQ1
As TEV=TUV, CS=0
Membership
or license
fee = CS
E
Q1
By Mr. LAU san-fat
MUV
Q
CH3-Consumer's Demand(1)
52
Ways to Extract Consumer's
Surplus(3)

By practicing 1st degree price
discrimination: charging the maximum
amount the consumer is willing to pay for
EACH unit, then P=MUV.
P, MUV
A
P1
P2
P3
P4
Remark:
TUV=area 0AEQ1
TEV=area 0AEQ1
As TUV=TEV, CS=0
E
MUV
0 1 2 3 4(Q1)
By Mr. LAU san-fat
Q
CH3-Consumer's Demand(1)
53
Why does Exchange Occur?


It is commonly, but wrongly, believed
that people trade because they have a
surplus of some goods.
In fact, trade or exchange occurs
because participants find it mutually
beneficial, because people place
different marginal valuations on scarce
goods.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
54
Assumptions behind the
Simple Exchange Model
1. Private property rights exist.
2. Transaction costs are zero.
3. There is no production taken place, i.e.
the stock of any good is fixed.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
55
Conditions for Conducting
Mutually Beneficial Exchange


Trade occurs when participants have
different marginal use value curves,
even though they have the same initial
endowment of a good.
Trade is still possible even trading
parties have the same MUV curves, if
their initial endowments are different.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
56
Exchange without Production



The individual with higher MUV will be the
buyer while the one with lower MUV will act
as the seller.
The seller is willing to engage an exchange if
the price he receives is higher than or equal
to the forgone MUV.
The buyer, however, will buy a unit only if
what he actually pays (P) is lower than or
equal to what he receives(MUV).
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
57
Exchange without Production



The actual trading price then lies
between the different initial MUVs of
the traders.
The equilibrium price is indicated at
where the two MUV curves intersect.
Exchange brings the MUVs of a good to
both parties to equality, and no further
trade would be mutually desired.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
58
Exchange without Production

Gains from exchange to the buyer:



Gains from exchange to the seller:



Per unit gain = MUV – P
Total gain = TUV – TEV
Per unit gain = P – MUV forgone
Total gain = TEV – TUV forgone
However, the distribution of gains from
exchange depends on the bargaining power
or pricing tactics of both trading parties.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
59
Exchange without Production



If the buyer has higher bargaining power, he
will enjoy most or all of the gains from trade
by obtaining the lowest possible price.
If, however, the seller has higher bargaining
power, he will capture most or all of the gains
from trade by requesting the highest possible
price.
As with normal shaped MUV curves, both
parties share the gains from trade.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
60
Exchange without Production:
An Illustration
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
61
Exchange without Production:
An Illustration
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
62
Transaction Costs & Exchange



There are substantial costs of finding trade
possibilities, or assessing the true
characteristics or qualities of goods, and of
negotiating exchange contracts and arranging
for such legal protections as warranties.
With the presence of transaction costs, the
gain from trade to traders are thus reduced.
As a maximizer, traders will seek ways to
reduce transaction costs and maximize their
gains from trade. And this could be done by
employing middlemen and using money.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
63
Exchange with Transaction
Costs and without Middlemen
Remarks: Let transaction costs be $1.5, of which
$0.5 is borne by seller while $1 by buyer.
Loss to
seller as
his net
realized
selling
price falls.
By Mr. LAU san-fat
Loss to buyer
as her full
price increases.
CH3-Consumer's Demand(1)
64
Exchange with Transaction
Costs and Middlemen
Remarks: Let middlemen costs be $0.75, of which
$0.5 is borne by buyer while $0.25 by seller.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
65
Exchange with Transaction
Costs and Middlemen


Whenever the fees charged by middlemen for
arranging and facilitating an exchange is
lower than the transaction costs being borne
by traders in conducting prepurchase search
and production inspection, trade is still
beneficial.
In an open market, competition among
middlemen reduces the spread between their
buying and selling prices to one that just
covers the costs of providing their services at
the quality wanted by the consumers.
By Mr. LAU san-fat
CH3-Consumer's Demand(1)
66