Principles of Economics
Class 2
Demand and consumer behavior
Utility
• Utility (u or TU)is a pleasure that consumer gains
when he consumes goods and services.
• Marginal utility MU is an increase in utility when
quantity of consumed products increases by one
unit.
• Law of diminishing MU states that MU becomes
diminishes when the amount of consumed goods
increases.
• Observation of marginal values was started in
1870’s bz Jevons, Menger and Walras.
Total utility and marginal utility
Indifference curves map
•Indifference curve is a curve that connects all the
baskets (combinations) of goods that give the same
value of pleasure to a consumer.
•Its slope is Marginal rate of substitution MRS which
tells what is the amount of good Y a consumer is willing
to give up in order to get additional unit of X staying on
the same level of utility.
qy
Indifference curves map
Δqx = 1
Δqy = MRSxy
u4
u3
u1
0
u2
qx
Budget
• Consumer can buy only those combinations
of
n
goods that satisfy the following rule:  p i q i  I
i 1
(where p = price and q = quantity)
• The slope of a budget line equal to ratio of
prices
• The area below and on the budget line is
affordable with the income I.
pxqx  p yq y  I
qy
qy 
I

py
I
py

px
py
0
I
px
qx
px
py
qx
Consumer equilibrium
• The equilibrium is obtained when budget line
is tangent to indifference curve.
• In that case there is no other consumer basket
on the budget line that can yield higher utility.
MRS
MRS
MU
x
MU
y

xy
px
py
xy



px
py
MU
x
MU
y
MU
px
x

MU
py
y
qy
qy 
MRS
xy


py
py
u3
u1
px
py
px
Affordable area
0
I
u2
qx
qx
Changes in the equilibrium
qy
Price of X falls
Price-consumption curve
u2
u1
0
qx
qy
Income increases
Income-consumption curve
u2
u1
0
qx
Income and substitution effect
• INCOME EFFECT is the change in the
consumer’s equilibrium due to a change in the
purchasing power.
• SUBSTITUTION EFFECT is the change in the
consumer’s equilibrium due to a change in
relative prices while retaining the same utilitz
level.
qy
qy 
MRS
Substitution
effect
xy


py
px
py
Income
effect
u1
0
I
u2
qx
px
py
qx
Deduction of an individual demand
qy
Px falls
u2
u1
0
qx
px
The smaller the price
of X, the greater its
demanded quantity
d
0
qx
Deduction of the market demand
p
Market demand is a horizontal
summation of individual demands
(competitive good)
dM
0
q
Causes of demand shifts
p
•Price of complement rises,
•Price of substitute falls
•Income falls (normal good),
•Income rises (inferior good)
•Good becomes less useful or more substitutable
d
0
q
•Price of complement falls,
•Price of substitute rises
•Income rises (normal good),
•Income falls (inferior good)
•Good becomes more useful or
less substitutable
p Consumer’s and producer’s surplus
Consumer surplus is the difference between
the price consumer pays and the price he was
willing to pay.
s
Consumer’s
surplus
Producer’s
surplus
E
Producer surplus is the difference between the
price the seller charges and the price at which
he was willing to sell.
d
0
q
Exercise 1
• Consumer buys 3 goods, A, B and C. The pleasure of consumption of these
goods increases as THE consumer increases the quantity:
Q=
1
2
3
4
A
95
165 210 240
B
400 700 900 1000
1020 1030
1038 1044 1048 1050
C
70
265
328
130 180 225
5
6
7
8
9
10
258
275
280
285
289
293
300
348
360
366
A) Calculate marginal utilities for each good
B) If the consumer has 52$ and prices of goods A, B and C are 1$, 2$ and 4$
respectively find the optimal consumption basket when consumer spends the
entire income.
C) What if income falls down to 36$?
D) Draw TU and MU for good B
Exercise 2
•
1)Let a consumer have the income of 150$ which can be spent on shirts and
pullovers. Price of a shirt is 5$ and price of a pullover is 24$. He spends the
entire income.
quantity
TU for shirts
TU for pullovers
1
2
3
4
5
6
7
60
115
165
210
250
285
315
400
750
1050
1300
1500
1650
1750
•
a)When consumers maximizes his utility?
•
MUx/Px=MUy/Py
•
•
•
3 combinations=>
1) 3(s) and 4(P) -> 3*5$ + 4*25$ = 115$
2) 5(s) and 5(P) -> 5*5$ + 5*25$ = 150$
3) 7(s) and 6(P) -> 7*5$ + 6*25$ = 185$
Consumer maximizes his utilitz when he buys 5 shirts and 5 pullovers
Total utility (TU) =TU(p)+TU(s)=250+1500 = 1750
•
b)Pri kojoj kombinaciji košulja i pulovera potrošač maksimizira svoju
korisnost ako se dohodak smanji na 115$ i kolika je ukupna korisnost?
•
Potrošač max. svoju korisnost pri kombinaciji od 4 pulovera i 3 košulja!
•
Ukupna korisnost(TU) =TU(p)+TU(k)=1300+165 = 1465
•
c)Is it possible to acquire the same level of utility if price of shirt 10$ and
price of pullover 50$ having the income of 280$?
•
TU =1750 for
A) 5 pullovers and 5 shirts (5*10$+5*50$) = 300$
B) 7 pullovers and 0 shirts (7*50$+0*10$) = 350$
•
It is no longer possible to maintain the previous level of utilitz with the
given prices and income.
Note: by how much changed prices and the income? It can give you an
immediate answer to c)!
•
•
Exercise 3
•
James is ready to pay 10 kn for the first bottle of coke, for the second 8 kn,
3rd 6 kn and 4th 4kn. Find his consumer surplus if the current price of a
bottle of coke is 4 kn.
•
•
•
TABLICA
Bottles of
coke
willing to pay
market price
consumer
surplus
1
2
3
4
10
8
6
4
4
4
4
4
6
4
2
0
CS =6+4+2+0 = 12!
b)If the price went up to 6 kn what is the amount of consumer’s surplus?
4+2+0 = 6 !
Exercise 4
• Demand and supply equations are qd = 10 –
2p and qs = 0.5p. Find CS, PS and the
equilibrium price and quantity.
• 10 – 2p = 0.5p => p*= 4, q*= 2.
• CS = (5 – 4)*2/2 = 1
• PS = (4 – 0)*2/2 = 4
• TS = 5