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1
Background to Demand
2
Background to Demand

• Marginal Utility Theory

3
MARGINAL UTILITY THEORY

• Total and marginal utility
• meaning of total utility
• marginal utility ?TU/?Q
• diminishing marginal utility
• total and marginal utility curves

4
Darrens utility from consuming crisps (daily)
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
5
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
6
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
MU in utils
- 7 4 2 1 0 -1
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
7
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
MU in utils
- 7 4 2 1 0 -1
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
MU
Packets of crisps consumed (per day)
8
Darrens utility from consuming crisps (daily)
TU
Utility (utils)
MU
Packets of crisps consumed (per day)
9
Darrens utility from consuming crisps (daily)
TU
DTU 2
DQ 1
Utility (utils)
MU DTU / DQ 2/1 2
MU
Packets of crisps consumed (per day)
10
MARGINAL UTILITY THEORY

• The optimum level of consumption the
  one-commodity version
• consumer surplus (total and marginal)
• marginal consumer surplus MU P
• total consumer surplus TU TE

11
Consumer surplus
MU, P
P1
MU
Q1
O
Q
12
Consumer surplus
MU, P
P1
Total consumer expenditure
MU
Q1
O
Q
13
Consumer surplus
MU, P
Total consumer surplus
P1
Total consumer expenditure
MU
Q1
O
Q
14
MARGINAL UTILITY THEORY

• The optimum level of consumption the
  one-commodity version
• consumer surplus (total and marginal)
• marginal consumer surplus MU P
• total consumer surplus TU TE
• maximising consumer surplus P MU
• Marginal utility and the demand curve

15
Deriving an individual persons demand curve
MU, P
MU D
O
Q
16
Deriving an individual persons demand curve
MU, P
a
P1
MU D
O
Q1
Q
17
Deriving an individual persons demand curve
MU, P
a
P1
b
P2
MU D
Q2
O
Q1
Q
18
MARGINAL UTILITY THEORY

• Limitations of the one-commodity version
• marginal utility affected by consumption of other
  goods
• marginal utility of money not constant
• Optimum combination of goods
• the equi-marginal principle
• MUA/MUB PA/PB
• deriving a demand curve

19
Background to Demand

• Risk, Uncertainty and Insurance

20
RISK, UNCERTAINTY AND INSURANCE

• Demand under conditions of risk and uncertainty
• defining risk and uncertainty
• types of odds
• risk attitudes
• Diminishing marginal utility of income and
  attitudes towards risk taking

21
Total utility of income
TU
Total utility
0
10 000
15 000
5000
Income ()
22
Total utility of income
TU
b
U2
a
U1
Total utility
0
10 000
15 000
5000
Income ()
23
Total utility of income
TU
c
U3
b
U2
a
U1
Total utility
0
10 000
15 000
5000
Income ()
24
Total utility of income
TU
c
U3
b
U2
d
U4
a
U1
Total utility
0
10 000
15 000
8000
5000
Income ()
25
RISK, UNCERTAINTY AND INSURANCE

• Insurance a way of removing risks
• How insurers spread risks
• the law of large numbers
• importance of the independence of risks
• Problems for insurers
• adverse selection
• moral hazard

26
Background to Demand

• Indifference Analysis

27
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve

28
Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Combinations of pears and oranges that Clive
likes the same amount as 10 pears and 13 oranges
29
Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
30
Constructing an indifference curve
a
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
31
Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
32
Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
c
Pears
d
e
f
g
Oranges
33
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution

34
Deriving the marginal rate of substitution (MRS)
MRS 4
DY 4
MRS ?Y/?X
Units of good Y
Units of good X
35
Deriving the marginal rate of substitution (MRS)
a
MRS 4
DY 4
b
26
MRS ?Y/?X
DX 1
Units of good Y
MRS 1
d
DY 1
6
7
Units of good X
36
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map

37
An indifference map
Units of good Y
Units of good X
38
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line

39
A budget line
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Assumptions PX 2 PY 1 Budget 30
40
A budget line
a
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
41
A budget line
a
Point on budget line a b
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
42
A budget line
a
Point on budget line a b c
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
Units of good X
43
A budget line
a
Point on budget line a b c d
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
d
Units of good X
44
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line
• effect of a change in income

45
Effect of an increase in income on the budget line
Units of good Y
Units of good X
46
Effect of an increase in income on the budget line
Units of good Y
Budget 40
Budget 30
Units of good X
47
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line
• effect of a change in income
• effect of a change in price

48
Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
49
Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
50
Effect on the budget line of a fall in the price
of good X
Assumptions PX 1 PY 1 Budget 30
Units of good Y
Units of good X
51
Effect on the budget line of a fall in the price
of good X
a
Assumptions PX 1 PY 1 Budget 30
Units of good Y
B2
B1
c
b
Units of good X
52
INDIFFERENCE ANALYSIS

• The optimum consumption point

53
Finding the optimum consumption
Units of good Y
O
Units of good X
54
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
55
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
56
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
57
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB

58
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
59
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income

60
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income
• the incomeconsumption curve

61
Effect on consumption of a change in income
Units of good Y
B1
I1
O
Units of good X
62
Effect on consumption of a change in income
Units of good Y
I2
B2
B1
I1
O
Units of good X
63
Effect on consumption of a change in income
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
64
Effect on consumption of a change in income
Income-consumption curve
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
65
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income
• the incomeconsumption curve
• the Engel curve

66
Deriving an Engel curve from an
income-consumption curve
Bread
I3
I2
I1
B3
B2
B1
CDs
67
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
I3
I2
I1
B3
B2
B1
CDs
68
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
I3
I2
I1
B3
B2
B1
CDs
Income ()
CDs
69
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd1
CDs
Income ()
CDs
70
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd1
CDs
Income ()
Y1
a
Qcd1
CDs
71
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd1
CDs
Income ()
Y2
b
Y1
a
Qcd2
Qcd1
CDs
72
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
Qb3
c
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd3
Qcd1
CDs
Y3
c
Income ()
Y2
b
Y1
a
Qcd3
Qcd2
Qcd1
CDs
73
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
Qb3
c
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd3
Qcd1
CDs
Engel curve
Y3
c
Income ()
Y2
b
Y1
a
Qcd3
Qcd2
Qcd1
CDs
74
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income
• the incomeconsumption curve
• the Engel curve
• income elasticity of demand and the
  incomeconsumption curve

75
Deriving an Engel curve from an
income-consumption curve
Bread
Income-consumption curve
Qb3
c
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd3
Qcd1
CDs
Engel curve
Y3
c
Income ()
Y2
b
Y1
a
Qcd3
Qcd2
Qcd1
CDs
76
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income
• the incomeconsumption curve
• the Engel curve
• income elasticity of demand and the
  incomeconsumption curve
• the effect of a rise in income on the demand for
  an inferior good

77
Effect of a rise in income on the demand for an
inferior good
Units of good Y (normal good)
I1
B1
O
Units of good X (inferior good)
78
Effect of a rise in income on the demand for an
inferior good
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
79
Effect of a rise in income on the demand for an
inferior good
Income-consumption curve
b
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
80
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve

81
Effect of a fall in the price of good X
Units of good Y
Units of good X
82
Effect of a fall in the price of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
B1
Units of good X
83
Effect of a fall in the price of good X
Assumptions PX 1 PY 1 Budget 30
Units of good Y
j
B1
Units of good X
84
Effect of a fall in the price of good X
a
Assumptions PX 1 PY 1 Budget 30
Units of good Y
j
I1
B1
B2
Units of good X
85
Effect of a fall in the price of good X
a
Units of good Y
j
I1
B1
B2
Units of good X
86
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve
• deriving the individual's demand curve

87
Deriving a demand curve from a price-consumption
curve
Expenditure on all other goods
B1
Units of good X
88
Deriving a demand curve from a price-consumption
curve
Fall in the price of X
a
Expenditure on all other goods
I1
B1
Units of good X
89
Deriving a demand curve from a price-consumption
curve
a
Expenditure on all other goods
I1
B1
Units of good X
90
Deriving a demand curve from a price-consumption
curve
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
91
Deriving a demand curve from a price-consumption
curve
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
92
Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
Price of good X
Q1
Units of good X
93
Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
a
P1
Price of good X
Q1
Q2
Units of good X
94
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve
• deriving the individual's demand curve
• Income and substitution effects of a price change

95
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good

96
Income and substitution effects normal good
Units of good Y
I1
I2
I3
I4
I5
I6
QX1
Units of Good X
97
Income and substitution effects normal good
Rise in the price of good X
Units of good Y
f
I1
I2
I3
I4
I5
B1
I6
QX3
QX1
Units of Good X
98
Income and substitution effects normal good
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1
I6
QX3
QX1
QX2
Units of Good X
99
Income and substitution effects normal good
g
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1a
B1
I6
QX3
QX1
QX2
Units of Good X
Substitution effect
100
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good
• an inferior good

101
Income and substitution effects Inferior
(non-Giffen) good
Units of good Y
I1
I2
QX1
Units of Good X
102
Income and substitution effects Inferior
(non-Giffen) good
Rise in the price of good X
Units of good Y
f
I1
I2
B1
QX3
QX1
Units of Good X
103
Income and substitution effects Inferior
(non-Giffen) good
Units of good Y
f
h
I1
I2
B1
B2
QX1
QX2
Units of Good X
104
Income and substitution effects Inferior
(non-Giffen) good
g
Units of good Y
f
h
I1
I2
B1
B2
B1a
QX3
QX1
QX2
Substitution effect
Units of Good X
105
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption curve
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good
• an inferior good
• a Giffen good (a special type of inferior good)

106
Income and substitution effects Giffen good
Units of good Y
I1
I2
QX1
Units of Good X
107
Income and substitution effects Giffen good
Rise in the price of good X
f
Units of good Y
I1
B1
I2
QX3
QX1
Units of Good X
108
Income and substitution effects Giffen good
f
Units of good Y
I1
h
B1
B2
I2
QX3
QX1
QX2
Units of Good X
109
Income and substitution effects Giffen good
g
f
Units of good Y
I1
h
B1a
B1
B2
I2
QX3
QX1
QX2
Units of Good X
Substitution effect
110
INDIFFERENCE ANALYSIS

• The effect of a change in price on the demand for
  other goods
• The usefulness of indifference analysis
• superiority of using ordinal measures
• limitations of indifference analysis