MICROECONOMICS TOPIC 2 Economics

DEMAND

UTILITY  Consumers get satisfaction from goods and services.  In economics this is called UTILITY.  Three ways to measure utility are:  How people react when consuming  How much of the product they consume  The price they are willing to pay.

UTILITY  Total utility is the total satisfaction a consumer will get from consuming a product over a period of time.  Marginal utility is the satisfaction gained from consuming an extra unit of a product.  Total utility is the total of the marginal utilities gained from each unit consumed.

DIMINISHING MARGINAL UTILITY  As someone consumes more of a product the utility gained from each extra unit decreases.  Total utility will continue to increase but at a slower rate, until a maximum is reached.  At this point there is no more satisfaction to be gained from consuming more of the product. Marginal utility will be zero.

EXAMPLE PINT OF BEERMARGINAL UTILITY TOTAL UTILITY First£2.00s worth Second£1.80s worth£3.80s worth Third£1.50s worth£5.30s worth Fourth£1.10s worth£6.40s worth

 If price was £2.00 the consumer would be willing to buy 1 pint because he gets £2 worth of satisfaction.  If the price was £1.80 he would be willing to buy 2 pints. He gets £2 worth of utility from the first pint and £1.80’s worth from the second.

 The information can be shown as a demand schedule.  This shows how much a consumer would be willing to buy at a range of prices. PriceQuantity Demanded £2.001 £1.802 £1.503 £1.104

CONSUMER SURPLUS  This is the difference between how much a consumer would be prepared to pay and what is actually paid.  If the price of beer was £1.80 a pint, the consumer would buy 2 pints. He was prepared to pay £2 for the first pint so he gets 20p of utility free, a consumer surplus of 20p

RATIONAL CONSUMER BEHAVIOUR  Economists believe that consumers act in a rational way.  This means they want the best value for money.  Not always possible due to:  imperfect knowledge  Action of other people  Lack of self-control.

 Assuming rational behaviour, a consumer will achieve maximum utility when the marginal utility spent on the last unit of each good is equal  This is called EQUI-MARGINAL RETURNS

Demand  Demand (or effective demand) is the quantity of a good or service which a consumer is ABLE and WILLING to buy at a particular price over a certain period of time.  Two types of demand exist: 1. INDIVIDUAL DEMAND – this is demand of one person for a product. 2. MARKET DEMAND – this is all the individual demand added together.

THE LAW OF DEMAND  The Law of Demand states:  that as the price of a product increases the demand for it will fall.  This happens for two reasons: 1. INCOME EFFECT – as the price of a product increases then a person’s real income falls. They are not ABLE to buy the same amount. 2. SUBSTIUTION EFFECT – as the price of a product increases people will swap to goods that are close to the original product. They are less WILLING to buy.

DEMAND CURVES  The demand curve slopes downward from left to right.  It shows that as price increases the quantity demand falls and vice versa.

PRICE QUANTITY TYPICAL DEMAND CURVE D D P Q P1 Q1

EXCEPTIONS TO THE LAW OF DEMAND These are goods or services where demand rises as price increases.  Goods of prestige, e.g. designer goods  Assumption of a link between price and quality – higher the price the better the quality.  Expectation of future price rises, e.g. buying shares.  Giffen goods – highly inferior goods, e.g. rice and potatoes.

PRICE QUANTITY EXCEPTIONS DEMAND CURVE

 The demand curve for the exceptions to the Law of Demand will slope upwards to begin with.  Eventually though it will resume the normal shape as the income effect kicks in.

 IT IS IMPORTANT TO REMEMBER THAT WHEN IT IS PRICE THAT CHANGES IT IS A MOVEMENT ALONG THE DEMAND CURVE.  INCREASE IN PRICE IS A CONTRACTION IN DEMAND.  DECREASE IN PRICE IS AN EXTENSION IN DEMAND.  DEMAND IS SAID TO HAVE RISEN BUT NEVER INCREASED!

CONDITIONS OF DEMAND CETERIS PARIBUS - This is Latin for other things remaining the same. It means that in Economics there is only ever one changing variable at a time.  Price is only one factor that might change the demand of a product, in reality there are many other factors.

OTHER CONDITIONS OF DEMAND  Disposable Income  demand for normal goods/inferior goods  Other goods  price goes up for one/effect on another e.g. Tea/Coffee  Effects on complimentary goods e.g. strawberries and cream  Population  Changes effects demand e.g. age  Tastes and preferences  fashionable goods; advertising campaign effects

EFFECT ON THE DEMAND CURVE  When it is a condition of demand, the demand curve will either shift to the left (decrease in demand) or shift to the right (increase in demand).  REMEMBER CETERIS PARIBUS. If it is a condition of demand price stays the same.

ELASTICITY OF DEMAND  Two types exist:  Price elasticity  Income elasticity

PRICE ELASTICITY OF DEMAND  This measures how responsive demand is to a change in price.  Measures how consumers react to the change of the price of a product.  FORMULA:  PED = % change in demand % change in price

ANSWERS  If PED is greater than 1, demand is very responsive to a change in price. Demand is PRICE ELASTIC  If the PED is less than 1, demand is not responsive to a change in price. Demand is PRICE INELASTIC.  If PED is 0, demand hasn’t changed, then demand is PERFECTLY INELASTIC.  If PED is equal to infinity, demand has changed without a change in price, the demand is PERFECT ELASTIC.  If PED is equal to 1, then demand has UNITARY ELASTICITY.

IMPORTANCE OF PRICE ELASTICITY  Firms really need to know about the elasticity of demand as it helps determine whether they should increase or decrease its prices.  Government need to know about it to determine whether to increase or decrease taxation.

PRICE ELASTIC DEMAND  When demand is price elastic it would be better for the firm to decrease the price.  Elastic demand means that even when there is a small change in price there is a big change in demand.  If the firm was to increase the price the revenue gained from the increase in price would be less than the revenue lost as a result of the drop in demand.

PRICE ELASTIC DEMAND DIAGRAM P1 P QQ1 D D Revenue Gain Revenue Loss

PRICE INELASTIC DEMAND  In this situation the firm would increase the price.  Inelastic demand means that even when there is a big change in price there is only a small change in demand.  The revenue lost from the small change in demand is outweighed by the revenue gained from the change in price. So total revenue will increase.

PRICE INELASTIC DEMAND DIAGRAM P1 P QQ1 D D Revenue Gain Revenue Loss

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND  Availability of substitutes – a product with a lot of substitutes will have elastic demand e.g. Nescafe.  Price relative to total spending – e.g. matches  Habit – any product that a consumer considers to be a necessity, then demand will be price inelastic. e.g. Petrol  Fashion – goods which are highly fashionable would be price inelastic e.g. IPhone  Frequency of purchase – products bought regularly would have price inelastic demand e.g. Milk

INCOME ELASTICITY OF DEMAND  This measures the responsiveness of demand to changes in income.  FORMULA:  IED = % change in demand % change in income

ANSWERS  When a person’s income increases by 10% it does not mean that they will buy 10% more than before.  Some commodities will still be unaffordable – 0 income elasticity  Some products they will be no more or no less of e.g. newspaper – 0 income elasticity  Some products they may only buy a little more of, e.g. food. These have income inelastic demand.  Some goods and services they will buy a lot more of, e.g. nights out. These have income elastic demand.

ANSWERS  Both income elastic and income inelastic demand are said to have POSTIVE INCOME ELASTICITY  Some products the consumer will buy less of, inferiors goods such as own brands. These have NEGATIVE INCOME ELASTICITY.

IMPORTANCE OF INCOME ELASTICITY  If a seller knows the income elasticity of their products they can predict what would happen to their products if incomes changed and how this would affect their revenue.  Also helps the government predict changes in revenue from taxes on products.