2016/17/12

CONSUMER BEHAVIOUR
AND DEMAND
Sara Hajiyeva
Enkhtsetseg Enkhbaatar
Mai Ho Hoang Vy
 We live in the world full of opportunities and wants. However, there are scarce goods that have
limitation for us. For example, water, food, gasoline, animals and etc. Sometimes, how much we need does
not coincide with what we want or have, so that is why people always tend to make choices. The objective
of this paper is to discuss the demand and consumer behavior whether goods are scarce or not.

One of the fundamental concepts of consumer behavior is utility theory. In economics, ‘utility’
refers to ‘satisfaction’. Utility theory was well explained by Dr.Whitaker. According to this theory, people
tend to produce and buy goods to fulfill their wants and needs. But, if these goods are in abundance, they
cannot bring as much satisfaction as when they are scarce. So, people will not work as hard as they can to
produce this kind of commodity. An economist sticks to the point that consumers tend to buy that bunch
of goods that bring them most satisfaction.

Total and Marginal Utility.

Total utility is” the aggregate level of satisfaction or fulfilment that a consumer
receives through the consumption of a specific good or service.
(http://www.investopedia.com, 2016). Total Utility rises consumption but at the decreasing rate. The
formula for calculation of total utility is following:
TUx = ∑MUx

Marginal (denotes ’extra’ or ‘additional’) utility is “the additional satisfaction a consumer gains from
consuming one more unit of a good or service” (http://www.investopedia.com).
One of the fundamental principles of economics is the law of diminishing marginal utility. According to this
law, as more of a product is consumed the marginal (additional) benefit to the consumer falls. To take an
example, there are two people, Jack and Anna. Assume that they went to shop to buy coffee, and Jack
bought his 4th cup, while Anna her 14th cup. The more they drink, the less extra satisfaction they get
(according to the law of diminishing returns). The satisfaction of drinking an extra cup of coffee for Jack
cannot be the same with that of Anna. Marginal utility defined as
      MU = ∆TU / ∆Q

To understand how the process works, we can take pizzas as an example. According to the table, as
the number of slices of pizzas increase, total utility will rise until the 7 th slice, where it will start to decrease
(increasing at the diminishing rate). However, marginal utility will decrease to even below zero. As it was
mentioned before, MU=Change in TU / Change in Q.

For example, eating the 2nd slice can bring 10 additional units of satisfaction (MU=(22-12)/1=10). The third
one is (30-22)/1=8, and eating the 7th slice of pizza is (39-41)/1=-2.

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 Number of Total utility Marginal
slices utility

1 12 -

2 22 10

3 30 8

4 36 6

5 40 4

6 41 1

7 39 -2

45
40
35
30
Total Utility

25
20
15
10
5
0
0 1 2Number
3 4of slices
5 6 7 8

3
 14
12
Marginal Utility 10
8
6
4
2
0
0 1 2 3 4 5 6 7 8
-2
-4
Number of slices

Equimarginal principle

According to this principle, a buyer can get the highest level of satisfaction when ‘the marginal utility of the
last dollar spent on a good is exactly the same as the marginal utility of the last dollar spent on any other
good’ (Samuelson and Nordhaus, p.87. 2010). To take an example, a consumer cannot get the same
satisfaction of spending the last dollar on buying bread and coat. Equimarginal principle can be defined in a
formula:
 MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn

I. An alternative approach: Substitution effect and income effect:

Apart from the concept of margin utility, substitution effect and income effect also help analyze the law of
downward-sloping demand.

1. Substitution effect:
Substitution effect is the most obvious factor for explaining downward-sloping demand curves. It is the
economic understanding that as prices rise, customers will have the tendency to substitute costly goods or
services for another now-cheaper ones in order to satisfy their desires more inexpensively. On the contrary,
when the economic welfare of customers increases, the opposite tends to be true.
Similarly, businesses also apply this way to the production process. To maximize the profits, when the rise
in the prices of inputs occurs, businesses will substitute low-priced inputs for high-priced inputs. Hence,
they can produce the given amount of outputs at the least total cost.
The substitution effect is depicted by the graph including Y-axis (units of products A) and X-axis (units of
product B). The demand of these products is concave, meaning that it has the high downward slope initially.
When the price of product A increases, customers who are sensitive t the prices will give up some amount of
product A to substitute product B. This coincides with the notion that the given up number of product A
decreases relatively to that of product B.
2. Income effect:
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The income effect represents how the customers’ behaviors change when having different levels of income.
To be more specific, when a price rises and money income is fixed, real income falls because the consumers
cannot afford the buy the same quantity of goods as before. This makes the term “income effect”. The term
“real income” means the actual quantity of goods that your money income can buy.
For example, when the price of apples increases and the income of customers stay the same, the quantity
demanded of apples will decrease. Another practice can be also considered as the income effect. It is when
the price of apples stay unchanged but customers receive higher salary then they have more incentives to
buy more apples than usual.
Income effect also have impacts on two or more goods. For instance, an increase in the price of sugar will
also decrease the quantity demanded of coffee, if the income is fixed. It is because sugar and coffee are
complementary products. Concerning substitution products, the rise in the price of one good will lead to the
increase in the quantity demanded of other good, holding income instant.
Income effect on luxuries goods is totally different from that on inferior goods. Obviously, there is a positive
correlation between luxuries goods and income, like yatches or air-plane tickets and reverse correlation
between inferior goods and income, such as bus tickets or canned food.

Income elasticity (YED): denotes the percentage change in quantity demanded divided by the percentage
change in income, holding other things, such as price, constant. Businesses usually use income elasticity of
demand to forecast sales and plan production for their products.

% change∈quantity demanded
Income elasticity =
% change∈income

There are variations in types of goods:

- Luxuries (income elastic): the demand for these goods rise rapidly as income increases – airline
travel. YED>1
- Normal goods (income inelastic): these products have a low but positive elasticity – milk, fruits.
0<YED<1
- Inferior goods: When an increase in income but less of goods is consumed – public
transportation. YED<0

For example:

Commodity Income elasticity

Automobile 2.46
Furniture 1.48
Books 1.44
Restaurant meals 1.40
Physician’s service 0.75
Tobacco 0.64
Pig products -0.2
Flour -0.36
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  Income elasticities are high for luxuries. Negative income elasticities are found for
inferior goods.
I. From individuals to market demand:
The demand curve for a good for the entire market is obtained by summing up the quantities demanded by
all the consumers
Each consumer has demand curve along which quantity demanded can be plotted against the price; it slopes
downward and to the right. If the demands are all the same, the market demand will be the total of
individuals. In fact, demands for goods of customers are different so that we calculate the sum total of what
all the different customers consume at each price

 At the price of $2, we add quantity demanded by each person to get the market quantity
demanded. The same application to the price of $1.
As a matter of convention, we label individual demand and supply curves with lowercase letter (dd and ss)
and market demand and supply with uppercase letters (DD and SS)

II. Demand shifts:

The demand curve shows how the quantity of a good demanded responds to a change in its own price.
A movement along the demand curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In other words, a movement occurs
when a change in the quantity demanded is caused only by a change in price, and vice versa.

Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity
demand is affected by a factor other than price. There are 5 main factors which can shift the demand curve:
Prices of related goods, Income, Population, Tastes, Other Special Influences.

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  Releasing new flavor increases the demand for beer; therefore, it shifts the demand curve
to the right.
III. Substitutions and Complements:
- Substitutes: an increase in the price of good A will increase the demand for substitute good B.
For example: the prices of pork and chicken
- Complements: an increase in the price of good A will decrease the demand for its complementary
good B.
For example: the prices of cars and gasoline
- Independent goods: a price change for one has no effect on the demand for the other.
For example: the prices of pork and cars

THE ECONOMICS OF ADDICTION

The government respect personal freedom about what to buy with their money. But in some cases of merit
goods such as free public education and emergency health care, and demerit goods whose consumption is
harmful to society, the government penalizes or forbids consumption of demerit goods involving addictions,
such harmful substances as heroin, marijuana, cigarettes, and alcohol. For a regular drug user, it is extremely
difficult to break the habit and thus ends up desire these substances than the nonuser. Moreover, the
demands for addictive substances are quite-inelastic.
The markets for addictive substances are big business. The National Survey on Drug Use and Health
suggests that in 2014, 27.0 million people aged 12 or older used an illicit drug in the past 30 days, which
corresponds to about 1 in 10 Americans (10.2 percent). Also, 139.7 million past month alcohol drinkers aged
12 or older in 2014. The National Drug Intelligence Centre estimated that in the most recent research, in
2007, the economic cost of illicit drug use totalled more than $193 billion. The findings are consistent with
prior work that has been done in this area using a generally comparable methodology (Harwood et al., 1984,
1998; ONDCP, 2001, 2004).
The market in illegal drugs promotes the predatory crime, spreads AIDS, corrupts law enforcement,
exacerbates poverty, and erodes the morality of society. Direct and indirect costs attributable to illicit drug
use are estimated in three principal areas: crime, health, and productivity (NDIC, 2011). The harms to users
include around 450,000 premature deaths annually, along with a wide variety of medical problems, 10,000
highway fatalities a year attributed to alcohol, and failures in personal life.

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 Economically, prohibiting the sale and the use of addictive
substance can be interpreted as a sharp upward shift in the supply
curve. After the upward shift, the price of the addictive substance
is much higher. During Prohibition (1920–1933), alcohol prices
were approximately 3 times higher than before. Cocaine currently
sells for at least 20 times its free-market price. Casual consumers
of illegal drugs have cheap substitutes like alcohol and tobacco
and thus will have relatively high price elasticity of demand. By
contrast, hard-core users are often addicted to particular
substances and have price-inelastic demands. We can illustrate the
market for addictive substances in Figure 5-4. The demand curve
DD’ is extremely price-inelastic for established users. A policy of
discouraging drug use by imposing large tax has the same effect
of shifting the supply curve from SS to S’S’. Because demand is price-inelastic, quantity demanded will
decline very little. At the higher price, total spending on drugs increases sharply. For illegal drugs, the
required outlays may be so great that the user engages in predatory crime. Although high price would reduce
the number of casual users who will be attracted into the market, it may drive users to other harmful
substances. For example, states that have criminal penalties for marijuana use tend to have higher teenage
consumption of alcohol and tobacco. Second, the prohibition of addictive substances yield negative
consequences rather than from their consumption. Many analysts conclude with the paradoxical observation
that the overall costs of addictive substances would be lower if the resources for government prohibitions
devoted to supply restrictions were instead put into treatment and counselling.
THE PARADOX OF VALUE

More than two centuries ago, in The Wealth of Nations, Adam

Smith posed the paradox of value: how is it that water, which is
essential to life, has little value, while diamonds? You can solve
this puzzle by distinguishing between total utility and marginal
utility. Diamonds have a small total utility relative to water, but
because we buy few diamonds, they have a high marginal utility.
Water has a low price and a low marginal utility.
The total utility from water consumption does not determine its
price or demand. Rather, water’s price is determined by its
marginal utility, by the usefulness of the last glass of water. Even
though the first few drops are worth for a thirsty man, the last few
are needed only for watering the lawn or washing the car. The
more there is of a commodity, the less is the relative desirability
of its last little unit.
CONSUMER SURPLUS
Another way to think about the paradox of value uses consumer surplus.
The supply of diamonds is perfectly inelastic at the quantity Q d so the
price of diamonds is Pd, and the consumer surplus is the small green
area. Water is cheap but brings a large consumer surplus, while
diamonds are expensive but bring a small consumer surplus (Parkin,
Powell & Matthews , 2005, pp. 151-153).
The gap between the total utility of a good and its total market value is
called consumer surplus. As a result of the law of diminishing marginal
utility, the earlier units are worth more to us than the last. Thus, we

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enjoy a surplus of utility on each of these earlier units. Because consumers pay the price of the last unit for
all units consumed, they enjoy a surplus of utility over cost. Consumer surplus measures the extra value that
consumers receive above what they pay for a commodity. Also, consumer surplus used for many public
decisions—such as deciding when the community should incur the heavy expenses of a road or bridge or set
aside land for a wilderness area.

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