Econ 201 Lecture 1.5 Consumer Demand Theory

Overview Basic behavioral assumptions Marginal Value or Marginal Willingness-to- Pay First Law of Demand Total WTP, Total Amount Paid, Consumer Surplus Individual and Market Demand Curves Factors that Shift Demand Curves More useful websites

Basic Behavioral Postulates 1.For each person some goods are scarce - have to make choices (core of the economic problem) 2.Each person desires many goods and services - tradeoffs 3.Each person is willing to forsake some of an economic good to get more of other economic goods - Opportunity costs – cost of foregone good to acquire another one 4.More one has of any good, the lower it personal marginal value - Diminishing marginal value 5.Not all people have the same tastes and preferences - Not all people get the same value from consuming a good - Provides a basis for exchange/trade even if everyone had same amount of goods 6.People are innovative and rational - People learn and behave in their own best self-interest (or at least are not systematically irrational – Becker)

First Law of Demand First law of demand, –The lower a good’s price it, the greater the quantity demanded (by an individual or the market) Demand –Entire schedule: quantity demanded at various prices Quantity demanded –The amount demanded at a given price

From the Demand Side First Law of Demand –What Does Law Of Demand Mean? –all other factors being equal, as the price of a good or service increases, consumer demand for the good will decrease and vice versa. – ms/l/lawofdemand.asp

Consumer’s Marginal Value Some basic definitions –Total Willingness-to-pay: “value in use” Maximum total amount you would be willing to pay for x units of the good than go without? –Equals the area under the demand curve up to x units Total Value of 4 units

All the things a demand curve tells you about value of the good Demand Curve is Also Marginal Value and Avg Revenue Amount Paid CS Total WTP = CS + Amt Paid

In Class Example Avg P*Qd TV(Q-1)+MV(Q) Also = MV(Q) TV(Q)-TV(Q-1) Tot Val- Tot Paid Also = Avg Rev

Buy Rules Consumer will buy a good as long as: – Total Willingness-to-Pay > Amount Paid There is always some consumer surplus, or incentive for consumer Consumer Surplus ≡ Difference (  ) between maximum amount that you are willing-to-pay and what you have to pay –CS ≡ Total WTP – Average Price x Qty Purhased Consumer will choose how much to buy (quantity demanded): –Marginal Value >= price paid for the last unit For Perfect Competition: price same for all units -> price paid for last unit = average price

What Does a Demand Curve Tell You? A Demand Curve is also –A Marginal Value Curve Tells you what the consumer’s marginal value of the last (incremental/additional) unit is –An Average Revenue Curve Tells you what the average price needs to be in order to sell x units

Individual Demand versus Market Demand Individual Demand curve –One individual’s willingness-to-pay or demand Market Demand curve –The sum of all individuals demand curves in the market

An Example PriceTomHarryDickMarket $ $91236 $82349 $ $ $ $ $ $ $

Market Demand: Maybe a little bit different Market Demand may be kinked as new buyers enter at different price points

Shift of the Entire Curve Shift out/right of the Demand Curve –WTP increases for all Q d Shift in/left of the Demand Curve –WTP decreases for all levels of Q d Shift out/right Shift in/left D2D2

Factors That Can Shift Demand Individual and Market Demand Curves –Income –Price of Substitutes –Price of Compliments –Product Quality –Future Prices –Taste and Preferences Market Demand Curves –Population (market)

Factors That Can Shift Demand Income –Normal good As income rises, quantity demanded increases at a given price -> Demand curve shifts out Superior good – percent of budget spent on good increases more than percent increase in income –Demand curve shift is very large –Inferior good As income rises, quantity demanded decreases at a given price –Demand curve shifts in

Factors That Can Shift Demand Substitutes –Goods that are similar to the “good in question” (or being analyzed) E.g., Pepsi/Coke Shifts in Demand Curve –If price of substitute increases, then demand for “GIQ” shifts out as it becomes relatively less expensive –If price of substitute decreases, then demand for “GIQ” shifts in as it becomes relatively more expensive –“closer” the substitute -> more demand curve shifts (i.e., greater cross-price elasticity) –For substitutes: relative price matters!

Factors That Can Shift Demand Complements –Goods that are “jointly consumed” with “GIQ”, e.g. coffee & cream Demand Curve shifts –Price of complement increases, then demand for “GIQ” shifts in as total cost of consumption has increased –Price of complement decreases, then demand for “GIQ” shifts out as total cost of consumption has decreased –For complements: total cost of consumption matters!

Factors That Can Shift Demand Product Quality –Better or improved product quality increases (relative) demand Demand curve shifts out Future price (hedge market) of the good –If the price is expected to go up in the future -> increases current demand (shift out/right) Cheaper to consume today and stockpile –If the price is expected to decrease in the future -> decrease current demand (shift in/left) Wait to buy (christmas/after christmas sales) Taste and Preferences –Always assumed constant unless you have empirical proof (new MRI imaging)

Factor that Affects the ONLY Aggregate Market Demand Curve As the population/number of buyers (Nb) increases -> Market Demand curve shifts outward

Key Assumptions Demand Curve For a given (individual’s) demand curve –These factors are held constant (ceteris paribus): Price of: –substitutes, –complements, –future price of the good income, quality, and taste and preferences And for a market demand curve: –number of buyers (Nb) Only price and quantity demanded are allowed to vary

A Short Quiz Seattle Times Oct 3, 2007 Olympic National Park officials are suggesting raising the price of an entrance pass for motorists — good for seven days — from $15 to $25 starting in 2009, with the fee for individuals such as cyclists climbing from $5 to $12. Season passes would increase from $30 to $50 But public response, particularly from tourist-dependent local businesses has been generally negative said a spokeswoman for Olympic National Park. 1.Illustrate the effect of the increase of the price for park passes on the demand for trips to the park 2.Illustrate how the park fee increase would affect the demand for other tourist-related businesses, e.g., hotels, restaurants.

A Take Home Problem

Useful Websites –Understanding differences between factors that cause shifts in demand or supply tmlhttp://hspm.sph.sc.edu/COURSES/ECON/SD/SD.h tml –Basics of demand and supply economics3.asphttp:// economics3.asp –Cobweb theorem 4.ppthttp:// 4.ppt

The Cobweb Theorem D S 7 Price (£) Quantity Bought and Sold (millions) 9 D1 In a ‘divergent cobweb’ - also termed an unstable cobweb - the price tends to move away from equilibrium. Assume the initial equilibrium price is £7 and the quantity 9. If demand rises, the shortage pushes the price up to £11 per turkey Farmers respond by planning to increase supply, ten months later, the supply of turkeys is 15 million. At this level, there will be a surplus of turkeys and the price drops. 8 The price falls to £5 and farmers react by cutting plans for turkey production. Ten months later, supply on the market will be 8 million. 5 This creates a massive shortage of 9 million turkeys and the price is forced up – and so the process continues! A divergent cobweb leads to price instability over time. 17

Cobweb Theorem Hungarian-born economist Nicholas Kaldor ( )Nicholas Kaldor Simple dynamic model of cyclical demand with time lags between the response of production and a change in price (most often seen in agricultural sectors). Cobweb theory is the process of adjustment in markets Traces the path of prices and outputs in different equilibrium situations. Path resembles a cobweb with the equilibrium point at the center of the cobweb. Sometimes referred to as the hog-cycle (after the phenomenon observed in American pig prices during the 1930s).

What We’ve Learned Sell rule for firms (Q s : P=MC) –Firms will supply y units up to the point where the MC of producing the next/last unit (y th ) is just equal to the price it receives for the good –First law of supply: supply curves will be upward sloping Buy rule for consumers (Q d : P=MV) –Consumers will buy x units up to the point that price equals MV for the last (x th ) unit First law of demand: demand curves are downward sloping Negative slope  diminishing marginal value of consuming next unit