Transcript Consumption & Exchange

Consumption Behaviour
& The Law of Demand
Consumer Demand --Deriving the Law of Demand by using
Marginal Use Value Approach
Law of Demand
P. 1
Six Behavioural Postulates of
Choice Theory
1. Each individual desires and
chooses many goods
2. Some goods are scarce for each
individual
3. Not all people choose the same
good since different individuals have
different preferences
Law of Demand
P. 2
Six Behavioural Postulates
4. Individuals are consistent in choice
5. People are willing to sacrifice some of
good in order to have more of another
(goods are substitutable)
6 Obey the Principle of Diminishing
Marginal Use Value, (the larger its
TUV, the lower its MUV).
Law of Demand
P. 3
Use Value

Use value of a good is defined as
the maximum amount of another
good a person is willing and able to
sacrifice in order to obtain that good.
Law of Demand
P. 4
TUV & MUV

Total use value (TUV) of a number of
goods refers to the amount of other
goods you are willing and able to
forgo in order to obtain the total
amount of that good.

Marginal use value (MUV) of a good
is the use value of an extra unit of a
good to an individual.
Law of Demand
P. 5
Number of apples an Marginal use value
individual possesses
of apples
per week
($)
Total use value of
apples
($)
0
-
0
1
10
10
2
9
19
3
8
27
4
7
34
5
6
40
6
5
45
7
4
49
Principle of Diminishing Marginal Use Value

The principle (postulate) of diminishing
marginal use values states that the
more an individual acquires a good,
the higher the total use value, but the
lower the marginal use value of each
additional unit of that good.
Law of Demand
P. 7
Deriving the Law of Demand

To derive the law of demand, we
have to introduce two concepts:
1. Consumer surplus
2. All individuals are Maximizers
Law of Demand
P. 8
Deriving the Law of Demand

Consumer surplus is defined as the
difference between total use value (TUV)
and total exchange value (I.e. total
expenditure) (TEV) of a good. That is the
extra amount of consumer is willing to
pay over and above what he or she
actually pays.
Consumer surplus = TUV - TEV
Law of Demand
P. 9
If the price of apples is $8 each, (1) how many
apples will the consumer buy and (2) what is the
amount of consumer surplus?
Number of apples an
individual possesses
per week
0
1
2
Marginal use value
of apples
($)
10
9
Total use value of
apples
($)
0
10
19
3
4
8
7
27
34
5
6
7
6
5
4
40
45
49
If the price of apples is $8 each, (1) how many
apples will the consumer buy and (2) what is the
amount of consumer surplus?
Number of apples an
individual possesses
per week
0
1
2
3
4
5
6
7
Marginal use value
of apples
($)
10
9
8
7
6
5
4
Total use value of
apples
($)
0
10
19
27
34
40
45
49
If the price of apples is $8 each, (1) how many apples will the
consumer buy and (2) what is the amount of consumer surplus?
Number of apples an
individual possesses
per week
Marginal use value of
apples
($)
Total use value of
apples
($)
0
-
0
1
10
10
2
9
19
3
8
27
4
7
34
5
6
40
6
5
45
7
4
49
Consumersurplus  T U V - T E
 $27  ($8 3)
 $27  $24
 $3
Marginal use value ($ per unit)
MUV
11
10
Consumer surplus
9
8
7
6
5
4
3
2
1
Q
0
1
2
3
4
5
6
7
8
9
Apples (unit per week)
10
P
MUV
11
10
9
8
7
6
5
4
3
2
1
0
MUV
=DD
Price ($ per unit)
Marginal use value ($ per unit)
People maximize consumer surplus
Q
11
10
9
8
7
6
5
4
3
2
1
0
DD=MUV
Consumer
equilibrium
A
B
Q
1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10
Apples (unit per week)
Apples (unit per week)
Deriving the Law of Demand


Since people maximize consumer
surplus,
hence the consumer equilibrium /
maximization condition is :
P  MUV
Law of Demand
P. 15
Validating the Law of Demand

Law of demand states that there is
an inverse relationship between the
price and quantity demanded,
keeping all other things constant.
Law of Demand
P. 16
Validating the Law of Demand


The empirical validity of the law of demand
does not depend on whether we can prove it
or not, it depends on whether it gives
accurate predictions.
Through many years of testing, economists
have not found a valid opposite example
that refutes this negative relationship, so
this relationship is confirmed, and has been
named as the law of demand.
Law of Demand
P. 17
Generalizing the Law of Demand

two general types of generalization
of the law of demand:
1. Price and Cost
2. Relative Price
Law of Demand
P. 18
Generalization of the Law of
Demand

The ‘price’ of a good is the same as
the ‘cost’ of obtaining the good.

The concept of ‘price’ is not confined to
‘money price’, and should be
generalized to ‘relative price’. I.e. the
price of a good in terms of another
good in real term
Law of Demand
P. 19
Real example

Let the price of a high-quality wine costs
$1,000 a bottle, and a low-quality wine
costs $500 a bottle in France.

When both of them are imported to Hong
Kong, adding the transportation cost of
$100 per bottle, the high-quality wine will
now cost $1,100 and the low-quality one
will cost $600.
What are the relative prices of high-quality wine and
low-quality wine in France and Hong Kong?
Real example
France
Relative price of
high-quality wine in
terms of low-quality
wine
Relative price of
low-quality wine in
terms of highquality wine
Hong Kong
decrease
$1,000
2
$500
$1,100
 1.83
$600
$500
 0.5
$1,000
$600
 0.55
$1,100
increase
Real example

According to the law of demand, the
decrease in relative price of the good
wine raise the quantity demanded of it,
while the increase in relative price of the
poor wine will reduce the quantity
consumed.

As a result, Hong Kong people will
consume a higher percentage of good
wine than France!
The Paradox of Value
Water-Diamond Paradox :
“Why is the price of water, which is
essential to human life, so much
lower than that of diamonds, which
are merely for decorative propose?”
Law of Demand
P. 23
The Paradox of Value:
Water-Diamond Paradox
The Solution:


Demand & Supply Analysis
Using marginal analysis on the
use value I.e. Total Use Value
at the margin ( MUV )
Law of Demand
P. 24
Water-Diamond Paradox

Demand & Supply Analysis
– Since the supply of water is
much larger than the supply of
diamonds, the price of a
diamond is much higher than
that of water.
Law of Demand
P. 25
Water-Diamond Paradox

TUV and MUV ----The ‘value’ of a
good depends on the ‘total use value’
(TUV) of it.

Since the quantity of water consumed
by the people is much larger than the
quantity of diamonds, the TUV of
water should also be larger than that
of diamonds.
Law of Demand
P. 26
TUV
P
P
S
TUV
D=MUV
0
Q
Diamond (unit per week)
S
D=MUV
Q
0
Water (unit per week)
Water-Diamond Paradox
TUV and MUV
– The ‘value’ of a good depends on the
‘total use value’ (TUV).
– The price of a good depends on the
‘marginal use value’ (MUV) of the last
unit of a good consumed by people.
Law of Demand
P. 28
P=MUV
P=MUV
P
P
S
S
D=MUV
0
Q
Diamond (unit per week)
D=MUV
0
Q
Water (unit per week)
Individual & Market Demand Curves

To derive the market demand curve,
we have to distinguish two kinds of
goods, the private good and the
public good.
Law of Demand
P. 30
Individual & Market Demand Curves

Private good is defined as a good
that can only be consumed by one
individual at a time.

Public good is defined as a good that
can be jointly consumed by many
people at the same time without
additional cost.
Law of Demand
P. 31
Person A
Person B
Market
Price of apples
($)
Quantity demanded
of apples per week
Quantity
demanded of
apples per week
Quantity
demanded of
apples per week
11
0
0
10
1
0
9
2
2
8
3
4
7
4
6
6
5
8
5
6
10
4
7
12
3
8
14
2
9
16
1
10
18
Person A
Person B
Market
Price of apples
($)
Quantity demanded
of apples per week
Quantity
demanded of
apples per week
Quantity
demanded of
apples per week
11
0
0
0
10
1
0
1
9
2
2
4
8
3
4
7
7
4
6
10
6
5
8
13
5
6
10
16
4
7
12
19
3
8
14
22
2
9
16
25
1
10
18
28
P
P
P
11
10
9
DA
DB
DA+B
4
3
7
Person A
Q
4
12
Person B
Q
7
19
Market
Q