Consumer Behavior and Demand Chapter 3

Characteristics of Consumer Behavior  Human wants are insatiable  More is preferred to less

Utility  Utility is defined as the amount of satisfaction received from a good or bundle of goods.  Cardinal measures of utility Numbers provide a measure of how much more you like one good over another  Ordinal measure of utility Numbers provide a measure preference ranking

Cardinal versus Ordinal measures

Law of Diminishing Marginal Utility  As a person consumes additional units of a product, they derive less satisfaction from each additional unit.  Marginal Utility is equal to the additional utility derived from consuming one more unit of a good.

Utility from Pizza

Utility from Trucks

Let’s throw in a John Deere tractor

Now let’s try that Kubota Wow, would you look at that!

Choices in Consumption Let’s move from one good to two now Pizza Slices Coke

Pizza Slices Coke This dot represents a consumption bundle for the consumer In math it is an ordered pair and can be calculated like this (# Cokes, # Pizzas) Choices in Consumption

Pizza Slices Coke This dot represents a consumption bundle for the consumer In math it is an ordered pair and can be calculated like this (# Cokes, # Pizzas) Therefore this bundle of goods is made up of one coke and seven pizza slices (1,7) Choices in Consumption

Pizza Slices Coke Several Ordered Pairs = (# Cokes, # Pizzas) These represent different consumption bundles for the consumer Choices in Consumption

Pizza Slices Coke (1,7) Choices in Consumption

Pizza Slices Coke (1,7) (2,5) Choices in Consumption

Pizza Slices Coke (1,7) (2,5) (10,1) Choices in Consumption

Pizza Slices Coke (1,7) (2,5) (10,1) (6,2) Choices in Consumption

Pizza Slices Coke (1,7) (2,5) (10,1) (6,2) (3,3) Choices in Consumption

Pizza Slices Coke (1,7) (2,5) (10,1) (6,2) (3,3) Choices in Consumption

Pizza Slices Coke This line is called an indifference curve It can be labeled I or U for Utility Curve I Choices in Consumption

Pizza Slices Coke Every point on an indifference curve gives the consumer the same level of utility or satisfaction Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous This one is not continuous Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous Convex to the origin Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous Convex to the origin This is not convex to the origin Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous Convex to the origin Fill the plane and never cross Choices in Consumption

Pizza Slices Coke Indifference curves are: Continuous Convex to the origin Fill the plane and never cross These cross and just make a mess. Choices in Consumption

Why can’t they cross?

Pizza Slices Coke The farther the indifference curve is away from the origin the better off the consumer is. The more of each good they have:-) Choices in Consumption

Pizza Slices Coke Better Off Worse Off Choices in Consumption

Pizza Slices Coke Indifference curves are convex to the origin this gives us the Law of Diminishing Marginal Rate of Substitution What is means is that we are willing to give up fewer and fewer slices of pizza to get an additional coke Choices in Consumption

Pizza Slices Coke Remember I said we are constrained, in other words we can’t get everything we want. How is that represented on this graph?

Choices in Consumption Pizza Slices Coke Let’s say we have $10 to spend a day on pizza and coke, what does that constraint look like? Well we need to know a couple other things like what are the prices of coke and pizza.

Choices in Consumption Pizza Slices Coke If the price of pizza is $2 a slice how many can we afford if we spend all our money income on pizza?

Choices in Consumption Pizza Slices Coke If the price of pizza is $2 a slice how many can we afford if we spend all our money income on pizza? The answer is 5 slices..

Choices in Consumption Pizza Slices Coke If the price of coke is $1 a glass how many can we afford if we spend all our money income on coke?

Choices in Consumption Pizza Slices Coke If the price of coke is $1 a glass how many can we afford if we spend all our money income on coke? The answer is 10 cokes..

Choices in Consumption Pizza Slices Coke These are the two endpoints of what is known as a budget constraint. You can afford to purchase one or the other...

Choices in Consumption Pizza Slices Coke The budget constraint shows every possible combination of goods that the consumer can purchase with a certain money income. In this case it’s $10..

Choices in Consumption Pizza Slices Coke How do we answer the question of how consumers choose how much of each to consume? Remember what a utility curve represents?..

Choices in Consumption Pizza Slices Coke Which point do you think the consumer will choose A, B or C? Why did you choose that point?.. A B C... I1I1 I2I2

Choices in Consumption Pizza Slices Coke Which point do you think the consumer will choose A, B or C? Why did you choose that point?.. A B C... I1I1 I2I2

Choices in Consumption Pizza Slices Coke What happens to the budget constraint when the price of a good changes? BC

Choices in Consumption Pizza Slices Coke If the Price of Coke doubles to $2.00 the budget constraint moves. More specifically it rotates clockwise with the Pizza slice endpoint staying the same. It rotates until the coke endpoint is on 5. BC

Choices in Consumption Pizza Slices Coke This is because we can only afford 5 cokes if when spend all of our income on coke now. BC 1 BC 2

Choices in Consumption Pizza Slices Coke What happens in a case where the prices of both pizza and coke double? BC

Choices in Consumption Pizza Slices Coke What happens in a case where the prices of both pizza and coke double? The new budget constraint shifts inward with the endpoints 2.5 pizza slices and 5 cokes. It is a parallel shift. BC 1 BC 2

Choices in Consumption Pizza Slices Coke How does our consumption change now? BC 1 BC 2

Choices in Consumption Pizza Slices Coke How does our consumption change now? BC 1 BC 2 A.

Choices in Consumption Pizza Slices Coke How does our consumption change now? We move from point A to Point B. BC 1 BC 2 A. B.

Choices in Consumption Pizza Slices Coke Now lets go back to the example where the price of coke goes from $1 to $2. How does that affect consumption? BC 1

Choices in Consumption Pizza Slices Coke Now lets go back to the example where the price of coke goes from $1 to $2. How does that affect consumption? BC 1 BC 2

Choices in Consumption Pizza Slices Coke Now lets go back to the example where the price of coke goes from $1 to $2. How does that affect consumption? BC 1 BC 2.

Choices in Consumption Pizza Slices Coke Now lets go back to the example where the price of coke goes from $1 to $2. How does that affect consumption? BC 1 BC 2..

Choices in Consumption Pizza Slices Coke Now lets go back to the example where the price of coke goes from $1 to $2. How does that affect consumption? BC 1 BC 2.

Choices in Consumption Substitution Effect - when the price of a good changes relative to another good, we substitute consumption towards the good that has become relatively less expensive. Income Effect - When the price of a good decreases the consumers real income has risen, thus creating the potential for consumption of both goods to increase.

Choices in Consumption Pizza Slices Coke Now lets see how we can use this utility analysis to map out a demand curve for this consumer BC 1. We start here with the price of coke at $1. When the price is $1 the consumer buys 5 cokes and 2.5 slices of pizza.

Choices in Consumption Pizza Slices Coke Now lets have the price of coke increasing from $1 to $2. How does that affect consumption? BC 1 BC 2..

Choices in Consumption Pizza Slices Coke Coke consumption goes from 5 units down to 3 units. The price goes up, consumption goes down. (Follows the Law of Demand) BC 1 BC 2..

Choices in Consumption Pizza Slices Coke Now lets map out this consumer’s demand curve. BC 1 BC 2..

Choices in Consumption Pizza Slices Coke Now lets map out this consumer’s demand curve. BC 1 BC 2.. How many cokes will this consumer buy at a price of $1……. 5 Cokes

Choices in Consumption Price Coke $ Coke (5, $1.00)

Choices in Consumption Pizza Slices Coke BC 1 BC 2.. How many cokes will this consumer buy at a price of $2……. 3 Cokes

Choices in Consumption Price Coke $ Coke (5, $1.00). (3, $2.00)

Choices in Consumption Price Coke $ Coke (5, $1.00). (3, $2.00)

Choices in Consumption Price Coke $ Coke (5, $1.00). (3, $2.00) Demand Curve for Coke

Choices in Consumption Now we need to be able to determine the market demand curve for a product like this coke for an individual.

Choices in Consumption Now we need to be able to determine the market demand curve for a product like this coke for an individual. The market demand curve is the horizontal summation of all individual demand curves for that particular good.

Choices in Consumption Price Coke $ Coke (5, $1.00). (3, $2.00) Jane’s Demand Curve for Coke

Choices in Consumption Price Coke $ Coke (5, $1.00). (2, $1.50) Bill’s Demand Curve for Coke

Choices in Consumption Price Coke $ Coke (5, $1.00). (2, $1.50) Bill’s Demand Curve for Coke. (5, $1.00). (3, $2.00) Jane’s Demand Curve for Coke

Choices in Consumption Price Coke $ Coke (5, $1.00). (2, $1.50) Bill’s Demand Curve for Coke. (5, $1.00). (3, $2.00) Jane’s Demand Curve for Coke. (4, $1.50)

Choices in Consumption Price Coke $ Coke (6, $1.50) (10, $1.00). (3, $2.00) Market Demand Curve for Coke..

Types of Demand

Elastic Demand - When the quantity response is relatively large compared to the price change.

Types of Demand Elastic Demand - When the quantity response is relatively large compared to the price change. Price Coke $ Coke Elastic Demand

Types of Demand Elastic Demand - When the quantity response is relatively large compared to the price change. Price Coke $ Coke Elastic Demand If you lower price total revenue increases

Types of Demand How is total revenue calculated?

Types of Demand How is total revenue calculated? It is the price of the product times the quantity sold

Types of Demand Price Coke $ Coke Elastic Demand. Total Revenue = $8 When Price = $2

Types of Demand Price Coke $ Coke Elastic Demand. Total Revenue = $12 When Price = $1

Types of Demand Inelastic Demand - When the quantity response is relatively small compared to the price change.

Types of Demand Inelastic Demand - When the quantity response is relatively small compared to the price change. Price Coke $ Coke Inelastic Demand

Types of Demand Inelastic Demand - When the quantity response is relatively small compared to the price change. Price Coke $ Coke Inelastic Demand If you lower price total revenue decreases

Types of Demand Remember total revenue is calculated by the price of the product times the quantity sold

Types of Demand Price Coke $ Coke Inelastic Demand Total Revenue =$6 When Price = $3.

Types of Demand Price Coke $ Coke Inelastic Demand Total Revenue = $5 When Price = $1.

Types of Demand Price Coke $ Coke Inelastic Demand Total Revenue = $5 When Price = $1.

Types of Demand Elasticity of Demand is considered to be Unitary when the Percentage changes in price and quantity demanded are the same. In this case an increase in price doesn’t change the level of income.

Types of Demand How do you calculate the Elasticity of Demand? Price Elasticity of Demand = %Change in Quantity % Change in Price

Types of Demand How do you calculate the Elasticity of Demand? Price Elasticity of Demand = Q 2 - Q 1 P 2 - P 1 Q 2 + Q 1 P 2 + P 1

Price Elasticity of Demand  Ed > 1, Elastic  Ed < 1, Inelastic  Ed = 1, Unitary Elastic One important note is that all of these elasticities are negative, So we just take the absolute value of them. The sign for a Price elasticity is meaningless.

Factors That Influence Demand Elasticities  How many close substitutes there are for the product  Whether or not there are many alternative uses for the product  Whether the product is a major expenditure in the consumers budget

Factors That Influence Demand Elasticities What is the difference between a Change in Quantity Demanded and a Change in Demand?

A change in Quantity Demanded Price Coke $ Coke Demand for Coke.

A change in Quantity Demanded Price Coke $ Coke Demand for Coke.. Price goes up from $1 to $3 and the Quantity Demanded goes down from 5 cokes to 2.

A change in Quantity Demanded Price Coke $ Coke Demand for Coke.. Notice the demand curve did not change, However the consumer’s position on that Demand curve did change.

A change in Quantity Demanded Price Coke $ Coke Demand for Coke.. A change in Quantity Demanded implies A movement along the demand curve. A price increase implies that Quantity Demanded decreases.

A Change in Demand Price Coke $ Coke Demand for Coke. A change in Demand implies A movement of the the demand curve.

A Change in Demand Price Coke $ Coke Demand for Coke. A change in Demand implies A movement of the the demand curve. New Demand for Coke

A Change in Demand Price Coke $ Coke Demand for Coke.. A change in Demand implies A movement of the the demand curve. Now at $3 the consumer demands 4.5 units instead of the initial 2. New Demand for Coke

A Change in Demand Price Coke $ Coke Demand for Coke.. A change in Demand implies A movement of the the demand curve. Now at $3 the consumer demands 4.5 units instead of the initial 2. Demand is said to have risen For this product. New Demand for Coke

What Creates Changes in Demand?  Population  Income  Tastes and Preferences  Related Product Prices  People’s Expectations

A Change in Demand from Population Price Coke $ Coke Demand for Coke An increase in Population shifts the demand curve outward. New Demand for Coke

A Change in Demand from Income Price Steak $ Steak Demand for Steak An increase in Income shifts the demand curve for Steak to the right New Demand for Steak

A Change in Demand from Income Price Spam $ Spam Demand for Spam An increase in Income shifts the demand curve for Spam or Rice to the left New Demand for Spam

A Change in Demand from a Change in Tastes and Preferences Price Health Food $ Q Health Food Demand for Health Food An increase in Health Concerns shifts the demand curve for Health Food to the right New Demand for Health Food

A Change in Demand from a Change in the price of a Related Good Price Coke $ Q Coke Demand for Coke An increase in the price of Pepsi shifts the demand curve for Coke to the right New Demand for Coke They are Substitutes

A Change in Demand from a Change in the price of a Related Good Price Hamburgers $ Q Hamburgers Demand for Hamburgers An increase in the price of French Fries shifts the demand curve for Hamburgers to the left New Demand for Hamburgers They are Complements

A Change in Demand from a Change in Consumer’s Expectations Price Gasoline $ Q Gasoline Demand for Gasoline If consumers expect there to be a shortage On gasoline, then the demand curve for Gasoline will shift to the right. New Demand for Gasoline

Income Elasticities Income Elasticity = % Change in Quantity of Product % Change in Income of Consumer

Income Elasticities Engel Curve – The relationship between the consumers income and the quantity he or she purchases of an item.

Engel Curve for Food Quantity Food Purchased Weekly Income in 000’s

Engel Curve for Clothing Quantity Clothing Purchased Weekly Income in 000’s

Income Elasticities Income Elasticity = Q 2 - Q 1 I 2 - I 1 Q 2 + Q 1 I 2 + I 1

Income Elasticities  Ei > 0, Normal Good  Ei < 0, Inferior Good  Ei> 1, Luxury  Ei< 1, Necessity

Cross Price Elasticities Cross Price Elasticities measure the responsiveness Of Demand for good 1 to a change in the price of good 2 Answers the question: How does the quantity demanded of coke Change from a change in the price of pepsi?

Cross Price Elasticities For Substitutes: An increase in the price of one Will increase the demand of the other. The Cross Elasticity of Coke for Pepsi is > 0 E c,p >0 Coke and Pepsi

Cross Price Elasticities For Complements: An increase in the price of one will decrease the demand of the other. The Cross Elasticity of Hamburgers for French Fries is < 0 E h,ff <0 Hamburgers and French Fries