MANAGERIAL ECONOMICS 11th Edition

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MANAGERIAL ECONOMICS 11th Edition

• By
• Mark Hirschey

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Consumer Demand

• Chapter 4

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Chapter 4OVERVIEW

• Utility Theory
• Indifference Curves
• Budget Constraints
• Individual Demand
• Demand Curves and Consumer Surplus
• Consumer Choice
• Optimal Consumption

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Utility Theory

• Benefits consumer obtain from the goods and
  services they consume.
• Assumptions About Consumer Preferences
• More is better (nonsatiation principle).
• Consumers can rank preferences.

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The Utility Function

• Shows an individuals perception of the level of
  utility that would be attained from consuming
  each conceivable bundle of goods.
• Descriptive statement relates well-being and
  consumption.
• A utility function is a descriptive statement
  that relates satisfaction or well-being to the
  consumption of goods and services.

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Marginal Utility

• The addition to total utility that is
  attributable to the addition of one unit of a
  good to the current rate of consumption, holding
  constant the amounts of all other goods consumed.
  

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Law of Diminishing Marginal Utility

• Marginal utility eventually declines for
  everything.

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Indifference Curves

• Indifference Curve
• A locus of points, representing different bundles
  of goods and services, each of which yields the
  same level of total utility or satisfaction. For
  simplicity we will continue to assume only 2
  goods.
• Indifference curves slope downward. This
  assumption reflects the fact that consumer obtain
  utility from both goods.
• Indifference curves are concave to origin.

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Indifference Curves

• Indifference curves are convex. This shape
  requires that as the consumption of X is
  increased relative to Y, the consumer is willing
  to accept a smaller reduction in Y for an equal
  increase in X, in order to stay at the same level
  of utility.

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Indifference Curves
Quantity of good Y
70
10
Quantity of good X
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Indifference Curves

• Perfect Substitutes and Perfect Complements
• Perfect substitutes satisfy the same need.
• Perfect complements are consumed together

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Budget Constraints

• Consumers are constrained in what they are able
  to do by the market-determined prices and their
  income.
• Basic Characteristics of Budget Constraints
• Shows affordable combinations of X and Y.
• Total Budget Spending on Goods Services
• B PYY PXX if we solve for Y

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• Budget Line
• The locus of all bundles of goods that can be
  purchased at given prices if the entire money
  income is spent.
• The slope of the budget line, PX/PY, indicates
  the amount of Y that must be given up if one more
  unit of X is purchased.

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• Example
• The consumer has a fixed income of 1,000. The
  price for X is 5 per unit and the price for of
  Y is 10 per unit.
• 5X 10Y 1000 or
• Y100 ½X
• If the consumer spends everything on Y and
  nothing on X, 100 units of Y can be purchased. If
  the consumer spends everything on X, 200 units of
  X can be purchased.

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Budget Constraint
Quantity of Y
Slope -1/2
100
80
40
200
40
120
Quantity of X
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• Effects of Changing Income and Changing Prices
• Budget increase causes parallel outward shift.
• Budget decrease causes parallel inward shift.
• Income and Substitution Effects
• Income effect Increase in overall consumption
  made possible by a price cut, or decrease in
  overall consumption that follows a price
  increase.
• Substitution effect Change in relative
  consumption that occurs as consumers substitute
  cheaper products for more expensive products

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Individual Demand

• Demand is the quantity of a good the consumer is
  willing and able to buy at each price in a list
  of prices, holding other things constant.
  Consumers maximize utility when the rate at which
  they are willing to substitute one good for
  another just equals the rate at which they are
  able to substitute.

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Individual Demand

• Price-consumption Curve
• Shows how consumption is affected by price
  changes (movement along demand curve).

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• Income-consumption Curve
• Shows how consumption is affected by income
  changes (shifts from one demand curve to
  another).
• The slope is positive because more Income more
  consumption.

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• Engle Curves
• Plot between income and quantity consumed.
• Consumption of normal goods rises with income.
• Consumption of inferior goods falls with income
  (rare).

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Engle Curves
Inferior Goods
Income
Income
Normal Goods
Engle Curve
Engle Curve
250
120
10
25
Services
Services
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Demand Curves and Consumer Surplus

• Graphing the Demand Curve
• Demand curves always slope downward.
• Consumer Surplus
• A fair price is paid of the amount required is
  just equal to the added benefit gained through
  consumption.
• Surplus Value received above amount paid.

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• Consumer Surplus and Two-Part Pricing. A common
  technique is to charge all customer a fixed fee
  per month or per year, plus a per unit usage
  charge.
• In general a firm can enhance profits by charging
  each customer a per unit fee equal to marginal
  cost, plus a fixed cost fee equal to the amount
  of consumer surplus generated at that per unit
  fee.
• Membership fees and user fees extract consumer
  surplus for the seller.

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Consumer Choice

• Marginal Utility and Consumer Choice
• Consumers seek to maximize the utility derived
  from consumption.
• Optimal consumption maximizes utility.
• Optimal consumption reflects marginal utility
  (benefits) and marginal costs.

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Optimal Consumption

• Marginal Rate of Substitution (MRS)
• The marginal rate of substitution measures the
  number of units of Y that must be given up per
  unit of X added so as to maintain a constant
  level of utility. The marginal rate of
  substitution diminishes along an indifference
  curve

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Indifference Curve
A
60
Quantity of Y
B
40
C
20
D
10
20
10
40
50
Quantity of X
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• The consumer is indifferent between combinations
  A (10X and 60Y) and B (20X and 40 Y). Thus the
  rate at which the consumer is willing to
  substitute is
• The marginal rate of substitution is 2, meaning
  that the consumer is willing to give up 2 units
  of Y each unit of X added. Since it would be
  cumbersome to have the minus sign on the right
  side of the equation, the MRS is defined as
• MRSXY -MUX/MUY and equals indifference curve
  slope.

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• MRSXY shows tradeoff in the amount of X and Y
  consumed, holding utility constant.
• MRSXY diminishes as amount of substitution of X
  for Y increases.

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• Utility Maximization
• A consumer maximizes utility subject to a limited
  money income at the combination of goods for
  which the indifference curve is just tangent to
  the budget line. At this combination, the MRS is
  equal to the Price Ratio
• A consumer maximizes utility when the Marginal
  Utility per dollar spent on the last unit of Good
  X equals the marginal utility per dollar spent on
  the last unit of good Y.
• Optimality requires PX/PY MUX/MUY.
• Optimality requires MUX/PX MUY/PY.

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• For example if MUX10 and PX2 MUX/PX 5,
  meaning that one additional dollar spent on X
  (which buys only ½ of a 2 unit of X) increases
  utility by 5 units, or one less dollar spent on X
  decreases utility by 5 units.
• The Consumption Path depicts optimal market
  basket as the budget level grows.

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Self Test Problem 1
 
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• B. S 3. When 3 units of goods are purchased,
  the last unit consumed generates 100 utils of
  satisfaction at a rate of 4 utils per dollar.
  Consumption of 3 units of services could also be
  justified on the grounds that consumption at that
  level would also generate 4 utils per dollar
  spent on services.
• C. G 4. When 5 units of services are
  purchased, the last unit consumed generated 60
  utils of satisfaction at a rate of 3 utils per
  dollar. Consumption of 4 units of goods could be
  justified on the grounds that consumption at that
  level would also generate 3 utils per dollar
  spent on goods.

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• D. G 3 and S 3.75. The optimal allocation of
  a 100 budget involves spending according to the
  highest marginal utility generated per dollar of
  expenditure. First, one unit of goods would be
  purchased since it results in 6 utils per dollar
  spent. Then, one units of services and another
  unit of goods would be purchased, each yielding 5
  utils per dollar. Then , a third unit of both
  goods and services would be purchased, thus
  yielding 4 utils per dollar. With thee units of
  goods and three units of services, a total of 75
  dollars will have been spent on goods and 60 on
  services. This totals 135 in expenditures, and
  leaves 15 unspent from a 150. budget.
  Assuming that partial units can be consumed, 15
  is enough to buy an additional 0.75 units of
  services.

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Self Test Problem 2
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• B. At one baseball game per month, MU 50.
  Thus, at a 25 price per baseball game, the cost
  per unit of marginal utility derived from
  baseball game consumption is P/MU 25/50
  0.50 or .50 per util.
• C. At a maximum acceptable price of 50? per util,
  Keaton's maximum acceptable price for baseball
  game tickets varies according to the following
  schedule

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