AAEC 2305 Fundamentals of Ag Economics Chapter 2 Economics of Demand

Objectives b To gain an understanding: About the Law of DemandAbout the Law of Demand How an individual’s budget limits the goods that can be purchasedHow an individual’s budget limits the goods that can be purchased About “Utility” & how an indifference curve is derivedAbout “Utility” & how an indifference curve is derived How a demand curve is determined by an individual ‘s budget & taste & preferencesHow a demand curve is determined by an individual ‘s budget & taste & preferences

Objectives (Cont.) The basic concepts of elasticity of demand, cross-price elasticity, and income elasticityThe basic concepts of elasticity of demand, cross-price elasticity, and income elasticity The determinants of demand elasticityThe determinants of demand elasticity

Introduction b In this chapter we will examine the economic concepts of consumption & demand. b Factors affecting the consumption decision: How much money an individual has to spend (budget)How much money an individual has to spend (budget) The scarce goods available in the marketplace & their pricesThe scarce goods available in the marketplace & their prices The individual’s taste & preferencesThe individual’s taste & preferences

Law of Demand b The law of demand states that, ceteris paribus, the quantity of a product demanded will vary inversely to the price of that product. As the price of a commodity increases, the quantity demanded of that product decreases.As the price of a commodity increases, the quantity demanded of that product decreases. As the price of a commodity decreases, the quantity demanded of that product increases.As the price of a commodity decreases, the quantity demanded of that product increases.

Consumption & Utility b Utility – the satisfaction derived from consuming a product, good, or service Since utility is derived from the inherent characteristics or qualities that make a product desirable, utility may be objective or subjective.Since utility is derived from the inherent characteristics or qualities that make a product desirable, utility may be objective or subjective. T/F, it is unlikely that two individuals would obtain the same level of utility (satisfaction) from the same amount of a product.T/F, it is unlikely that two individuals would obtain the same level of utility (satisfaction) from the same amount of a product.

Consumption & Utility b Util - a hypothetical numerical measurement of utility (used to represent the satisfaction derived from consuming products)

Marginal Utility b Marginal Utility (MU) – addition to total utility (TU) provided by the last unit of the good consumed MU = Δ TU / Δ ConsumptionMU = Δ TU / Δ Consumption b MU is the utility provided by the last unit of the good consumed b MU is central to understanding consumption decisions & the law of demand.

Law of Diminishing Marginal Utility b Law of Diminishing Marginal Utility - as additional units of a good are consumed a point is always reached where the utility derived from each additional unit declines.

Example

Example (Cont.)

Budget Constraint b Budget – amount of money (from salary, loans, dividends, etc.) available for purchases in a given time period. We all have a limited amount of money to use for consumptionWe all have a limited amount of money to use for consumption Our budget constrains or limits how much we can buyOur budget constrains or limits how much we can buy

Budget Constraint b Budget Constraint – price & availability of goods in the market, along with the size of the budget, place a constraint on consumption. b Budget and budget constraint are represented by the budget line.

Budget Line b Budget Line – a line indicating all combinations of two goods that can be purchased using all of the consumer’s budget. TB = (P g1 * G 1 ) + (P g2 * G 2 )

Example Assume TB = 30, P g1 = 1, & P g2 = Total Expenditure G2G1

Budget Line b Every combination of goods along the budget line can be purchased for the same total expenditure. b The distance from the origin is an indication of the size of a the budget. The closer to the origin, the lower the budget and vice versa.The closer to the origin, the lower the budget and vice versa.

Budget Line b Only purchases on the budget line use all of the consumer’s budget. b The utility maximizing combination - where consumption is optimum - lies somewhere on the budget constraint.

Effects of Budget Changes b A budget increase will result in a parallel shift of the budget line to the right b Conversely, a budget decrease will result in a parallel shift of the budget line to the left. b Ex. of a budget increase

Effects of a Price change b If the price of one good changes, slope of budget line changes b Ex. of price change

Indifference Curves b Indifference Curve (IC) - a line showing all combinations of two goods (products) that provide the same level of utility b T/F, each combination of products along the IC provides the same level of utility i.e., the consumer is indifferent between themi.e., the consumer is indifferent between them

Indifference Curves b Each combination of goods provides the same level of utility. b The downward slope of the IC indicates that if the consumer gives up one good, the resulting loss in utility must be compensated for by consuming additional units of the other commodity for utility to remain constant.

Indifference Curves b Since each IC represents a unique level of utility, an IC exists for each level of utility a consumer is capable of experiencing. b T/F, the distance from the origin indicates the level of utility b T/F, each IC represents a unique utility level - - Hence, IC can never intersect b Additionally, the whole set of IC is called an indifference map.

Indifference Curves b As we move along the IC the utility level remains the same but quantities of goods consumed change as one good replaces (or substitutes) for the other. b Marginal rate of substitution (MRS) - rate one good must or can decreased as consumption of the other good increases i.e., rate at which one good can physically substitute for another in the consumption processi.e., rate at which one good can physically substitute for another in the consumption process

Marginal Rate of Substitution b MRS is the slope of the indifference curve. b Marginal Rate of Substitution of G2 for G1 (MRS G2G1 ) =  G1 /  G2 =  replaced /  added b MRS G2G1 =  G1 /  G2 = MU G2 / MU G1

Marginal Rate of Substitution MRS G2G1 G2G2G2G2 G1G1G1G1

Possible MRS Relationships b Imperfect Substitutes – diminishing MRS; one good can be exchanged for another, but at a decreasing rate. b Perfect (Constant) Substitutes – constant MRS; one unit of a good can be exchanged for another on a constant basis. b Perfect Complements – Fixed Proportions; goods must be consumed in a fixed ratio

Consumer Choice Problem b The basic problem a consumer faces is how to allocate the budget among various goods to maximize utility (satisfaction). b A rational consumer maximizes utility by consuming as many goods as desired, within the limits imposed by the budget. i.e. - the consumer buys goods that provide the most utility per dollar spent.i.e. - the consumer buys goods that provide the most utility per dollar spent.

Utility Maximization Decision b Obj. of the consumer is to find the combination of goods that provides the maximum amount of utility for his/her given budget (income). b T/F, the consumer wants to reach the highest possible level of utility, given their budget constraint. b I.e., consumer wants to find tangency between the highest possible indifference curve (utility) and the budget line (budget constraint).

Utility Maximization Decision b Tangency occurs where slope of the indifference curve equals the slope of the budget line. b MRS G2G1 = IPR b  G1 /  G2 = P G2 / P G1 b Can be viewed as: (  G1 * P G1 ) = (  G2 * P G2 ) “Budget Savings” = “Budget Expenditures”

Utility Maximization Decision

b Recall – b MRS G2G1 =  G1 /  G2 = MU G2 / MU G1 b We can specify (MRS G2G1 = IPR) as: MU G2 / MU G1 = P G2 / P G1 MU G2 / P G2 = MU G1 / P G1 * Utility max occurs where MU per dollar spent is equal for the two goods.

Impact of Changes in Product Prices b IF P G2 increases- G2 becomes relatively more expensive than G1G2 becomes relatively more expensive than G1 The slope of the budget line increases and the budget line rotates inwardThe slope of the budget line increases and the budget line rotates inward The consumer can no longer afford to remain on original indifference curve and must reduce consumptionThe consumer can no longer afford to remain on original indifference curve and must reduce consumption T/F, the consumer will consume less of G2 and more of G1.T/F, the consumer will consume less of G2 and more of G1.

Impact of Changes in Product Prices b IF P G2 decreases- G2 becomes cheaper relative to G1G2 becomes cheaper relative to G1 The slope of the budget line decreases and the budget line rotates outwardThe slope of the budget line decreases and the budget line rotates outward The consumer can afford to move to a higher indifference curve and can increase consumptionThe consumer can afford to move to a higher indifference curve and can increase consumption T/F, the consumer will consume more of G2 and less of G1.T/F, the consumer will consume more of G2 and less of G1.

Deriving a Demand Curve b Demand Schedule – information on price and quantity (consumption) combinations that give the consumer maximum utility, ceteris paribus. b Demand Curve – a line connecting all combinations of price and quantities consumed Each point on a demand curve gives the price and quantity combination of a good that a consumer will buy, given his or her budget constraint and the prices of other goods.Each point on a demand curve gives the price and quantity combination of a good that a consumer will buy, given his or her budget constraint and the prices of other goods.

Demand Curve b The demand curve slopes downward and to the right. b Each point on the demand curve gives a quantity of the good that a consumer will buy to maximize utility. b Refer to class example on how to derive a demand curve.

Elasticity of Demand (E D ) b Elasticity of demand is defined as the percentage change in the quantity demanded relative to a percentage change in the price as we move from one point to another on a demand curve. b Elasticity of demand represents movement along the demand curve and thus elasticity is also a measure of the degree of slope of the demand curve.

Elasticity of Demand (E D ) b Mgrs. & Economists are interested in two types of demand elasticity measures: Own-price elasticity: measures the responsiveness of the quantity demanded of a good to changes in the price of that good.Own-price elasticity: measures the responsiveness of the quantity demanded of a good to changes in the price of that good. Cross-price elasticity: measures the responsiveness of the quantity demanded of a good to changes in the price of a related good.Cross-price elasticity: measures the responsiveness of the quantity demanded of a good to changes in the price of a related good.

Own-Price Elasticity of Demand b The own-price elasticity of demand is calculated as follows: b E D = %  Q D / %  P b E D = %  Q D / %  P b E D = ((Q 2 -Q 1 )/(Q 2 +Q 1 )) / ((P 2 -P 1 )/(P 2 +P 1 ))

Classifications of Own-Price Elasticity of Demand b Classifications: Inelastic demand ( |E| < 1 ): a change in price brings about a relatively smaller change in quantity.Inelastic demand ( |E| < 1 ): a change in price brings about a relatively smaller change in quantity. Unitary elastic demand ( |E| = 1 ): a change in price brings about an equivalent change in quantity.Unitary elastic demand ( |E| = 1 ): a change in price brings about an equivalent change in quantity. Elastic demand ( |E| > 1 ): a change in price brings about a relatively larger change in quantity.Elastic demand ( |E| > 1 ): a change in price brings about a relatively larger change in quantity.

Cross Price Elasticity of Demand b E D AB = ((Q 2A – Q 1A ) / (Q 2A + Q 1A )) / ((P 2B – P 1B ) / (P 2B + P 1B )) b Shows the percentage change in the quantity demanded of good A in response to a change in the price of good B. b Read as the cross-price elasticity of demand for commodity A with respect to commodity B.

Classification of Cross-price elasticity of Demand b Substitutes in consumption (E D AB > 0): implies that as the price of good B increases, the quantity demanded of Good A by the consumer also increases (& vice versa). b Complements in consumption (E D AB < 0): implies that as the price of good B decreases, the quantity demanded of Good A by the consumer also increases (& vice versa). b Independent in consumption (E D AB = 0): implies that the price of good B has no effect on quantity demanded of Good A.

Income Elasticity of Demand (E D I ) b Since a demand curve represents the amount at each price that consumers are WILLING and ABLE to purchase, the amount of income available to consumers has a direct effect on their effective demand. b If consumer’s income increases (decreases), the position of the demand curve will also change (shift).

Income Elasticity of Demand (E D I ) b The direction of the shift depends on if the good is a normal or inferior good. Normal good (aka as superior good)– demand increase with income (& vice versa)Normal good (aka as superior good)– demand increase with income (& vice versa) Inferior good – demand decreases with increases in income (& vice versa)Inferior good – demand decreases with increases in income (& vice versa)

Income Elasticity of Demand (E D I ) b E D I = %  Q D / %  I  b E D I = %  Q D / %  I  b E D I = ((Q 2 -Q 1 )/(Q 2 +Q 1 )) / ((I 2 -I 1 )/(I 2 +I 1 ) b If E D I > 0, then the good is considered a normal good. b If E D I < 0, then the good is considered an inferior good.

Engel’s Law b The percentage of total income spent on food generally declines as income increases resulting in an income elasticity of demand for the total quantity of food less than one, a relationship known as Engel’s Law.