Transcript Consumer Behavior and Individual Demand

AAEC 3315
Agricultural price Theory
Chapter 2
Consumer Behavior and Individual Demand
Objectives

To gain an understanding of:






How an individual’s budget limits the goods
that can be purchased
About “Utility”
Indifference curves and Budget lines
Utility Maximization Decision
Derivation of the Demand Curve and the Law
of Demand
Derivation of the Engel Curve
Consumption & Demand

Factors affecting the consumption decision:

An individual’s taste & preferences

How much money an individual has to spend
(budget)

Price of the goods in the marketplace
Consumption & Utility

Utility – the satisfaction derived from
consuming a product, good, or service

Since utility is derived from the inherent
characteristics or qualities that make a product
desirable, utility may be objective or subjective.

Util - a hypothetical numerical measurement of
utility (used to represent the satisfaction
derived from consuming products).
Total Utility and Marginal Utility

Total Utility (TU) – total satisfaction derived
from consumption of a good.

Marginal Utility (MU) – addition to total utility
(TU) provided by the last unit of the good
consumed


MU = Δ TU / Δ Consumption = ∂TU/∂Q
MU is the utility provided by the last unit of the
good consumed
Example
Total Utility Curve
80
70
60
Total Utility
Consumption Total Utility
(doughnuts)
0
0
1
24
2
44
3
60
4
69
5
73
6
73
7
68
50
40
30
20
10
0
0
1
2
3
4
Doughnuts
5
6
7
8
Example (Cont.)
Consumption Total Utility
(doughnuts)
0
0
2
3
4
>
24
>
20
20
>
16
>
9
60
69
4
10
5
0
1
2
3
4
-5
0
-10
73
68
15
0
73
>
7
25
44
>
6
30
24
>
5
Marginal Utility Curve
Marginal Utility
1
Marginal
Utility
-5
Doughnuts
5
6
7
8
Law of Diminishing Marginal Utility
Law of Diminishing Marginal Utility - as
additional units of a good are consumed a
point is always reached where the utility
derived from each additional unit declines.
Example (Cont.)
Consumption Total Utility
(doughnuts)
0
0
1
2
3
4
5
6
7
Marginal
Utility
>
24
>
18
>
10
>
4
>
0
>
-1
>
-10
24
42
52
56
56
55
45
Indifference Curves

Indifference Curve (IC) - a line showing all combinations of
two goods (products) that provide the same level of utility
i.e., the consumer
Qy
is indifferent
between them

Y2
As we move along the
IC the utility level
remains the same but
Y1
quantities of goods consumed
change as one good replaces
(or substitutes) for the other.
IC
X1
X2
Qx
Characteristics of Indifference Curves




The closer to the origin, the
lower the level of utility and
vice versa.
Each IC represents a unique
utility level - - Hence, IC can
never intersect
ICs are negatively sloped. The
downward slope of the IC
indicates that if the consumer
consumes less of one good,
she would consume more of
the other (for utility to remain
constant).
The whole set of IC is called an
indifference map.
Qy
IC2
IC1
Qx
Indifference Curves

Marginal rate of substitution (MRS) – The number of units of one
good that must be given up to receive an extra unit of another
good, holding the level of satisfaction constant.
Qy

MRSXY = Y / X
Y2
Y

MRS is the slope of the
Y1
X
indifference curve.
IC
X1
X2
Qx
Marginal Rate of Substitution
Y
Y
25
X
MRSXY= Y/X
5
-6
19
1
-6
2
-2.50
3
-1.33
4
-0.75
5
-0.40
6
-5
14
8
-4
10
11
-3
7
15
-2
5
X
20
Diminishing Marginal Rate of
Substitution



More the consumer has of a particular good, say X, the
less of another good, say Y, he would be willing to
give up to obtain an additional unit of X.
That is, MRS of X for Y
gets smaller as the
consumer has more of X
and less of Y.
This is applicable only
if Y and X are
imperfect substitutes.
Y
IC
X
Budget Constraint


Budget Constraint – price & availability of
goods in the market, along with the size of
the budget, place a constraint on
consumption.
Budget and budget
constraint are
represented by
the budget line.
Y
X
Budget Line

Budget Line – a line indicating all combinations of
two goods that can be purchased using all of the
consumer’s budget, i.e., I = X Px + Y Py

Assume I = 30, PX = 1, & PY = 2
X
30
24
18
12
0
Y
0
3
6
9
15
Total Expenditure
30
30
30
30
30
Budget Line

Every combination of goods along the budget line
can be purchased for the same total expenditure.

The distance from
the origin is an indication
of the size of a the budget.


Y
The closer to the origin, the
lower the budget and vice versa.
Only purchases on the
budget line use all of the
consumer’s budget.
X
Budget Line

I = X Px + Y Py
OR

Y = I/Py – (Px / Py) X

Where, I/Py is the
Y-intercept, I/PX is
the X-intercept and
- (Px / Py) is the slope
Y
I/PY
Slope = - (Px / Py)
I/PX
X
Effects of Budget Changes
Y

A budget increase
(decrease) will result
in a parallel shift of the
budget line to the right
(left)
X
Y

If the price of one
good changes, slope
of budget line
changes
X
Review of Budget Line and
Indifference Curve



Y
Budget Line: a line
indicating all combinations
of two goods that can be
purchased using all of the
consumer’s budget.
Only purchases on the
budget line use all of the
consumer’s budget.
X
Y
Indifference Curve (IC):
a line showing all combinations
of two goods (products) that
provide the same level of utility.
IC3

ICs that are higher in graphs
represent greater level of satisfaction.
IC2
IC1
X
Consumer Choice Problem


The basic problem a consumer faces is
how to allocate the budget among various
goods to maximize utility (satisfaction).
That is, the consumer’s objective is to
select from all combinations of goods
within his means (i.e., combinations on his
budget line) the one that gives him the
maximum utility (i.e., the one that lies on
the highest indifference curve.)
Utility Maximization Decision
Y
U
T
S
V
IC3
IC2
W
IC1
X
Utility Maximization Decision
Y
U
S
It is then clear that from all the
market baskets that are within the
consumer’s reach, market basket
“V” would give the consumer the
maximum utility.
T
V
IC3
W
IC2
IC1
X
Note that the market basket V is
at a point where the budget line is
tangent to IC2.
Thus, the slope of the budget line
should be equal to the slope of the
indifference curve.
Utility Maximization Decision



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Slope of the budget line = PX / PY
Slope of the indifference curve
= MRSXY = Y / X
Thus at the point of tangency:
MRS = Y / X = PX / PY
Thus, the consumer maximizes his utility
where MRS is equal to the ratio of prices.
Impact of Changes in Product Prices

IF PX increases- X becomes relatively more
expensive than Y
Y



The slope of the budget
line increases and the budget
line rotates inward
The consumer can no longer
afford to remain on original
indifference curve and must
move to a lower indifference
curve
The new equilibrium will be at S.
S
V
W
IC2
IC1
X
Impact of Changes in Product Prices

IF PX decreases- X becomes cheaper relative to Y
Y
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

The slope of the budget line
decreases and the budget line
rotates outward
The consumer can afford to
move to a higher indifference
curve
The new equilibrium will be at S
V
S
IC1 IC2
X
Price Consumption Curve (PCC)
Y

The PCC connects points
representing equilibrium market
baskets corresponding to all
possible levels of the price of
good X, while price of Y and
income remain the same.
PCC
a
b
c
IC1
IC2 IC3
X
Deriving a Demand Curve
An individual’s demand curve for a particular
good is derived from the individual’s budget
(budget line) & taste & preferences
(indifference curve) or the PCC.
The law of demand states that, ceteris paribus,
the quantity of a product demanded will vary
inversely to the price of that product.
Y
PCC
W
Y3
Y2
Y1
V
S
IC1
X1
X2
IC2
X3
IC3
X
Price of X
P1
P2
P3
Demand Curve for X
X
X1
X2
X3
Deriving a Demand Curve
Demand Curve – a line connecting
all combinations of price and
quantities consumed


Each point on a demand curve
gives the price and quantity
combination of a good that a
consumer will buy, given his or
her budget constraint and the
prices of other goods.
As the price of a commodity
increases (decreases), the
quantity demanded of that
product decreases (increases).

The demand curve slopes
downward and to the right.

Each point on the demand
curve gives a quantity of the
good that a consumer will buy
to maximize utility.
P1
Price of X

P2
P3
Demand Curve for X
X1
X2
X3
X
Impact of Changes in Income

A change in income results in a
parallel shift of the budget line
(slope stays unaffected as long
as the prices remain constant)


With change in income, the
consumer’s utility maximizing
market baskets change from “u”
to “v” to “w.”
If we connect all of the points
representing utility maximizing
market baskets (u, v, and w)
corresponding to all possible
levels of income, the resulting
curve is call the Income
Consumption Curve.
Y
ICC
w
U
V
W
X
Deriving an Engel Curve
The ICC can be used to derive an Engel
Curve, which are important for studies of
family expenditure patterns.
The Engel Curve describes the relationship
between a consumer’s income and his
expenditure on a specific good.
Y
ICC
w
U
V
X
I
Engel Curve
I3
I2
I1
X1
X2
X3
X
Deriving an Engel Curve

Engel Curve – a line connecting all
combinations of income and
quantities consumed



Each point on an engel curve
gives the income and quantity
combination of a good that a
consumer will buy, given the
prices of all goods.
As the income increases
(decreases), the quantity
demanded of that product
increases (decreases). This is
true only for normal goods.
The shape of the engel curve for
a particular good will depend on
the nature of the good, the
nature of the consumer’s taste,
and the level at which the
commodity prices are held
constant.
I
Engel Curve
I3
I2
I1
X1 X2 X3
X