Principles of Economics Demand and consumer behavior 1 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. 2 Total utility and marginal utility 3 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. 4 q2 Indifference curves map Δq1 = 1 Δq2 = MRS12 u4 u3 u1 0 u2 q1 5 Budget • Consumer can buy only those combinations of goods that satisfy the following rule: 𝑝1 𝑞1 + 𝑝2 𝑞2 ≤ 1 (where p = price and q = quantity) • When consumer spends the entire budget: 𝑝1 𝑞1 + 𝑝2 𝑞2 = 𝐼, 𝑜𝑟 𝑞2 = 𝐼 𝑝2 − 𝑝1 𝑞1 𝑝2 • The slope of a budget line equal to ratio of prices, 𝑝1 − 𝑝2 • The area below and on the budget line is affordable with the income I. 6 p1q1 p2 q2 I q2 I p1 q2 q1 p2 p2 I p2 p1 p2 0 I p1 q1 7 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. p1 MRS12 p2 MU1 MRS12 MU 2 MU1 p1 MU1 MU 2 MU 2 p2 p1 p2 8 q2 I p1 q2 q1 p2 p2 MRS12 p1 p2 u3 Affordable area u1 0 u2 q1 9 Changes in the equilibrium q2 Price of X falls Price-consumption curve u2 u1 0 q1 q2 Income increases Income-consumption curve u2 u1 0 q1 10 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 utility level. 11 q2 Substitution effect Income effect u1 0 u2 q1 12 Deduction of an individual demand q2 P1 falls u2 u1 0 q1 p1 The smaller the price of X, the greater its demanded quantity d 0 q1 13 Deduction of the market demand p Market demand is a horizontal summation of individual demands (competitive good) dM 0 q 14 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 15 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 16 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) Draw TU and MU for good B 17 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$. He spends the entire income. quantity TU for shirts TU for pullovers 1 2 3 4 5 6 7 60 115 165 210 250 285 315 400 750 1050 1300 1500 1650 1750 • a)When consumers maximizes his utility? • MUx/Px=MUy/Py 18 • • • 3 combinations=> 1) 3(s) and 4(P) -> 3×5$ + 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 utility when he buys 5 shirts and 5 pullovers Total utility (TU) =TU(p)+TU(s)=250+1500 = 1750 19 • b)If the income falls down to 115$ what would be the utility maximizing quantity of shirts and pullovers?? • 4 shirts and 3 pullovers! • Total utility (TU) =TU(p)+TU(k)=1300+165 = 1465 20 • 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)! • 21 • 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 ! 22 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 = CS + PS = 5 23