AAEC 2305 Fundamentals of Ag Economics

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AGEC 220
Consumer Behavior Demand
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Objective

• Objective examine the consumers decision-making
  process.
• The consumer decision involves allocating a
  limited amount of money (budget) among various
  commodities in order to maximize utility.
• Utility - the satisfaction derived from consuming
  a product, good, or service.

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Assumptions

• 1) Consumer wants to maximize utility
• 2) Consumer has a limited income
• 3) Two goods are considered, all others are
  assumed to be fixed
• Consumers goal is to allocate limited income
  across the two goods so that his/her utility will
  be maximized.

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Physical Relationships

• Want to analyze the physical aspects of
  consumption
• Utility -
• Since utility is derived from the inherent
  characteristics or qualities that make a product
  desirable, utility may be objective or
  subjective.
• T/F, it is unlikely that two individuals would
  obtain the same level of utility (satisfaction)
  from the same amount of a product.

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Physical Relationships

• Util - a hypothetical numerical measurement of
  utility (used to represent the satisfaction
  derived from consuming products)

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Example
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Physical Relationships

• Marginal Utility (MU) - addition to total utility
  (TU) provided by the last unit of the good
  consumed
• MU ?TU / ? Consumption
• MU in the table indicates that TU increases at a
  decreasing rate

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Example
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Physical Relationships

• Law of Diminishing Marginal Utility - as
  additional units of a good are consumed a point
  is always reached where the utility derived from
  each successive unit declines.

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Physical Relationships

• Indifference Curve (IC) - a line showing all
  combinations of two goods (products) that provide
  the same level of utility
• T/F, each combination of products along the IC
  provides the same level of utility
• i.e., the consumer is indifferent between them

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Example

• Each combination of goods provides the same level
  of utility.
• The downward slope of the IC indicates that if
  the consumer gives up one good, the resulting
  loss in utility must be compensated for by
  consuming additional units of the other commodity
  for utility to remain constant.

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Physical Relationships

• Since each IC represents a unique level of
  utility, an IC exists for each level of utility a
  consumer is capable of experiencing.
• T/F, the distance from the origin indicates the
  level of utility
• T/F, each IC represents a unique utility level -
  - Hence, IC can never intersect

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Physical Relationships

• As we move along the IC the utility level remains
  the same but quantities of goods consumed change
  as one good replaces (or substitutes) for the
  other.
• Marginal rate of substitution (MRS) - rate one
  good must or can decreased as consumption of the
  other good increases
• i.e., rate at which one good can physically
  substitute for another in the consumption process

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Physical Relationships

• MRS is the slope of the indifference curve.
• Marginal Rate of Substitution of G2 for G1
  (MRSG2G1) ?G1 / ?G2 ?replaced / ?added
• MRSG2G1 ?G1 / ?G2 MUG2 / MUG1

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Example
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Possible MRS Relationships

• Imperfect Substitutes diminishing MRS one good
  can be exchanged for another, but at a decreasing
  rate.
• Perfect (Constant) Substitutes constant MRS
  one unit of a good can be exchanged for another
  on a constant basis.
• Perfect Complements Fixed Proportions goods
  must be consumed in a fixed ratio.

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Economic Relationships

• Budget amount of money available for purchases
  in a given time period.
• Budget Constraint price availability of goods
  in the market, along with the size of the budget,
  place a constraint on consumption.

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Economic Relationships

• Budget and budget constraint are represented by
  the budget line.
• Budget Line a line indicating all combinations
  of two goods that can be purchased using all of
  the consumers budget.
• TB (Pg1 G1) (Pg2 G2)

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Example Assume TB 30, Pg1 1, Pg2 2
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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.
• The closer to the origin, the lower the budget
  and vice versa.

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Effects of a Price Change

• If the price of one good changes, slope of budget
  line changes (IPR also changes)
• Ex. of price change

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Utility Maximization Decision

• Obj. of the consumer is to find the combination
  of goods that provides the maximum amount of
  utility for his/her given budget (income).
• T/F, the consumer wants to reach the highest
  possible level of utility, given their budget
  constraint.
• I.e., consumer wants to find tangency between the
  highest possible indifference curve (utility) and
  the budget line (budget constraint).

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Utility Maximization Decision

• Tangency occurs where slope of the indifference
  curve equals the slope of the budget line.
• MRSG2G1 IPR
• ?G1 / ?G2 PG2 / PG1
• Can be viewed as
• (?G1 PG1) (?G2 PG2)
• Budget Savings Budget Expenditures

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Example Assume TB30, PG11, PG22
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Impact of Changes in Product Prices

• IF PG2 increases-
• G2 becomes relatively more expensive than G1
• 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 reduce
  consumption
• T/F, the consumer will consume less of G2 and
  more of G1.

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Impact of Changes in Product Prices

• IF PG2 decreases-
• G2 becomes cheaper relative to G1
• The slope of the budget line decreases and the
  budget line rotates outward
• The consumer can afford to move to a higher
  indifference curve and can increase consumption
• T/F, the consumer will consume more of G2 and
  less of G1.

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Deriving a Demand Curve

• Demand Schedule information on price and
  quantity (consumption) combinations that give the
  consumer maximum utility, ceteris paribus.
• 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.

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Demand

• Demand is based on a inverse price quantity
  relationship.
• The amount of a product that consumers are
  WILLING and ABLE to purchase at each price level
  determines how much of a product is demanded at
  that price.

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Derivation of Market Demand Curve

• The market demand curve is given by the
  horizontal summation of all individual consumers
  demand curves.

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Example
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Example
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Law of Demand

• Law of Demand states that the quantity of a
  product demanded will vary inversely to the price
  of that product.
• As the price of a commodity increases, the
  quantity demanded of that product decreases.
• As the price of a commodity decreases, the
  quantity demanded of that product increases.

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Elasticity of Demand (ED)

• Elasticity of demand the percentage change in
  the quantity demanded relative to a percentage
  change in the price as we move from one point to
  another on a demand curve.
• Elasticity of demand represents movement along
  the demand curve and thus elasticity is also a
  measure of the degree of slope of the demand
  curve.

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Elasticity of Demand (ED)

• Classifications
• Inelastic demand ( E lt 1 ) a change in price
  brings about a relatively smaller change in
  quantity.
• Unitary elastic demand ( E 1 ) a change in
  price brings about an equivalent change in
  quantity.
• Elastic demand ( E gt 1 ) a change in price
  brings about a relatively larger change in
  quantity.

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Elasticity of Demand (ED)

• Mgrs. Economists are interested in two types of
  demand elasticity measures
• Own-price elasticity measures the
  responsiveness of the quantity demanded of a good
  to changes in the price of that good.
• Cross-price elasticity measures the
  responsiveness of the quantity demanded of a good
  to changes in the price of a related good.

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Elasticity of Demand (ED)

• ED ? QD / ? P ltorgt
• ED ((Q2-Q1)/(Q2Q1)) / ((P2-P1)/(P2P1))
• In class examples

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Elasticity of Demand (ED) Total Revenue

• Inelastic Demand As price increases, total
  revenue increases (and vice versa)
• Unitary Elastic Demand As price changes, total
  revenue does not change)
• Elastic Demand As price increases, total
  revenue decreases (and vice versa)

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Cross-price elasticity of Demand

• EDAB ((Q2A Q1A) / (Q2A Q1A)) / ((P2B P1B)
  / (P2B P1B))
• Shows the percentage change in the quantity
  demanded of good A in response to a change in the
  price of good B.
• Read as the cross-price elasticity of demand for
  commodity A with respect to commodity B.

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Classification of Cross-price elasticity of
Demand

• Substitutes in consumption (EDAB gt 0) implies
  that as the price of good B increases, the
  quantity demanded of Good A by the consumer also
  increases ( vice versa).
• Complements in consumption (EDAB lt 0) implies
  that as the price of good B decreases, the
  quantity demanded of Good A by the consumer also
  increases ( vice versa).
• Independent in consumption (EDAB 0) implies
  that the price of good B has no effect on
  quantity demanded of Good A.

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Change in Demand versus Change in Quantity
Demanded

• Change in quantity demanded results from changes
  in the price of the product being examined and
  are movements along a demand curve.
• Change in demand results from changes in the
  quantity purchased due to factors other than a
  change in the product price. (i.e. shift in the
  demand curve)

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Determinants of Demand

• QD f(own price price availability of
  substitutes goods, income, population, tastes
  preferences)
• Quantity demanded will vary with price as long as
  the four demand shifters are held constant or
  fixed.

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Income Elasticity of Demand (EDI)

• Since a demand curve represents the amount at
  each price that consumers are WILLING and ABLE to
  purchase, the amount of income available to
  consumers has a direct effect on their effective
  demand.
• If consumers income increases (decreases), the
  position of the demand curve will also change
  (shift).

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Income Elasticity of Demand (EDI)

• The direction of the shift depends on if the good
  is a normal or inferior good.
• Normal good (aka as superior good) demand
  increase with income ( vice versa)
• Inferior good demand decreases with increases
  in income ( vice versa)

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Income Elasticity of Demand (EDI)

• EDI ? QD / ? I? ltorgt
• EDI ((Q2-Q1)/(Q2Q1)) / ((I2-I1)/(I2I1)
• If EDI gt 0, then the good is considered a normal
  good.
• If EDI lt 0, then the good is considered an
  inferior good.