Part C- Background to Demand

Demand and the consumer

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 Household Consumption Choices
A household’s consumption choices are determined by:
 Consumption possibilities
 Preferences

Consumption Possibilities
A household’s consumption possibilities are constrained by its
budget and the prices of the goods and services it buys.
A budget line describes the limits to a household’s
consumption choices.

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 Household Consumption Choices
This figure shows a budget line.

The household can afford all the points on

or below the budget line.

The household cannot afford the points

beyond the budget line.

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 Household Consumption Choices
Preferences
A household’s preferences determine the benefits or
satisfaction a person receives consuming a good or service.
The benefit or satisfaction from consuming a good or service
is called utility.
Total Utility
Total utility is the total benefit a person gets from the
consumption of goods. Generally, more consumption gives
more utility.

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Household Consumption Choices
 This figure shows a total utility curve.

 Total utility is the total satisfaction a

consumer gets from the consumption
of all the units of good consumed
within a given time period.

 Total utility increases with the

consumption of a good.

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Household Consumption Choices

Marginal Utility
Marginal utility is the change in total utility that results from a
one-unit increase in the quantity of a good consumed.
As the quantity consumed of a good increases, the marginal
utility from consuming it decreases.
We call this decrease in marginal utility as the quantity of the
good consumed increases the principle of diminishing
marginal utility.

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 Example 1: Relationships between Total Utility And
Marginal Utility

Number of Apples 1 2 3 4 5 6 7 8

Total Utility 20 38 53 64 70 70 65 54
Marginal Utility 20 18 15 11 6 0 -5 -11

 When MU is positive, TU keeps on increasing.

 When MU falls, TU increases at a decreasing rate.

 When MU is zero, TU is maximum.

 When MU is negative, TU is decreasing.

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 Relationships between Total Utility and Marginal
Utility
80

70 70 70
64 65
60

53 54
50

40
38

30

20 20
18
15
10 11
6
0 0
1 2 3 4 5 6 7
-5 8
-10 -11

-20

Total Utility Marginal Utility

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Household Consumption Choices

This figure illustrates

diminishing marginal utility.

Utility is analogous to
temperature.
Both are abstract concepts
and both are measured in
arbitrary units.

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 Maximizing Utility
The key assumption of marginal utility theory is that the
household chooses the consumption possibility that maximizes
total utility.
The Utility-Maximizing Choice
We can find the utility-maximizing choice by looking at the total
utility that arises from each affordable combination.

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Maximizing Utility

Equalizing Marginal Utility per Dollar Spent

Using marginal analysis, a consumer’s total utility is
maximized by following the rule:
Spend all available income and equalize the marginal
utility per dollar spent on all goods.
The marginal utility per dollar spent is the marginal
utility from a good divided by its price.

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 Maximizing Utility

 Call the marginal utility of movies MUM

 Call the marginal utility of soda MUS
 Call the price of movies PM
 Call the price of soda PS
 The marginal utility per dollar spent on movies is MUM/PM
 The marginal utility per dollar spent on soda is MUS/PS

Total utility is maximized when:

MUM/PM = MUS/PS
LOOK EXAMPLE 1 page 27
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 EXAMPLE 2:
You have $16 to spend on dessert
•Price of Ice Cream=$2
•Price of Cake = $ 4 per Slice

Quantity of TU MU MU/Pi Quantity TU MU MU/Pc

Ice Cream Ice Ice of Cake Cake Cake
Cream Cream
1 4 1 10
2 3 2 18
3 2 3 24
4 1 4 28
5 0 5 30

Determine each of following:

•The total utility of Ice Cream and the marginal utility of Cake.

•The optimal combinations of ice cream and cake.

•The amount of total utility.

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Maximizing Utility

If MUM/PM > MUS/PS, then

moving a dollar from soda to
movies increases the total
utility from movies by more
than it decreases the total utility
from soda, so total utility
increases.

Only when MUM/PM =

MUS/PS, is it not possible to
reallocate the budget and
increase total utility.
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 Maximizing Utility
Similarly, if MUS/PS > MUM/PM,
then moving a dollar from
movies to soda increases the
total utility from soda by more
than it decreases the total utility
from movies, so total utility
increases.
Again, only when
MUM/PM = MUS/PS, is
it not possible to
reallocate the budget
and increase total
utility. 15
Predictions of Marginal Utility Theory

A Fall in the Price of a Movie

When the price of a good falls the quantity demanded of that
good increases—the demand curve slopes downward.
For example, if the price of a movie falls, we know that
MUM/PM rises, so before the consumer changes the quantities
consumed, MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum total utility), the
consumer increases the quantity of movies consumed to drive
down the MUM and restore MUM/PM = MUS/PS.

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 Predictions of Marginal Utility Theory

A change in the price of one good changes the demand for

another good.
You’ve seen that if the price of a movie falls, MUM/PM rises, so
before the consumer changes the quantities consumed,
MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum total utility) the
consumer decreases the quantity of soda consumed to drive
up the MUS and restore MUM/PM = MUS/PS.

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Predictions …

A fall in the price of a movie

increases the quantity of movies
demanded—a movement along
the demand curve for movies,

and decreases the demand

for soda—a shift of the
demand curve for soda.

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Predictions of Marginal Utility Theory

A Rise in the Price of Soda

Now suppose the price of soda rises.
We know that MUS/PS falls, so before the consumer changes
the quantities consumed, MUS/PS < MUM/PM.
To restore consumer equilibrium (maximum total utility) the
consumer decreases the quantity of soda consumed to drive
up the MUS and increases the quantity of movies consumed
to drive down MUM. These changes restore MUM/PM =
MUS/PS.

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Predictions
A rise in the price of soda
decreases the quantity of
soda demanded—a
movement along the
demand curve for soda,

and increases the

demand for movies—
a shift of the demand
curve for movies.

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 Predictions of Marginal Utility Theory
Marginal Utility and Elasticity
We can predict the price elasticity of demand for a good
by knowing the characteristics of the marginal utility of the
good.
If as the quantity consumed, marginal utility diminishes
rapidly, then a given price change will bring a small
quantity change to restore consumer equilibrium, and
demand will be inelastic.

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 Consumption Possibilities
Household consumption choices are constrained by its
income and the prices of the goods and services available.
The budget line describes the limits to the household’s
consumption choices.

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 Consumption Possibilities
This Figure shows a consumer’s
budget line.

Divisible goods can be bought in

any quantity desired along the
budget line (gasoline, for example)
Indivisible goods must be bought in
whole units at the points marked
on the budget line (movies, for
example).

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Consumption Possibilities
The Budget Equation
We can describe the budget line by using a budget
equation.
The budget equation states that
Expenditure = Income
Call the price of soda PS, the quantity of soda QS, the price
of a movie PM, the quantity of movies QM, and income Y.
Lisa’s budget equation is:
PSQS + PMQM = Y.

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 Consumption Possibilities

PSQS + PMQM = Y
Divide both sides of this equation by PS, to give:
QS + (PM/PS)QM = Y/PS
Then subtract (PM/PS)QM from both sides of the equation to
give:
QS = Y/PS – (PM/PS)QM
The term Y/PS is Lisa’s real income in terms of soda.
The term PM/PS is the relative price of a movie in terms of
soda.

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 Consumption Possibilities
A household’s real income is the income expressed as a
quantity of goods the household can afford to buy.
Lisa’s real income in terms of soda is the point on her
budget line where it meets the y-axis.
A relative price is the price of one good divided by the
price of another good.
It is the magnitude of the slope of the budget line
The relative price shows how many sodas must be
forgone to see an additional movie.

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 Consumption Possibilities

A fall in the price of the good on

the x-axis increases the
affordable quantity of that good
and decreases the slope of the
budget line.
This figure shows the rotation
of a budget line after a change
in the relative price of movies.

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 Consumption Possibilities

An change in the household’s

income brings a parallel shift of
the budget line.
The slope of the budget line
doesn’t change because the
relative price doesn’t change.
This figure shows the effect of
a fall in income.

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Preferences and Indifference Curves

An indifference curve is a line

that shows combinations of
goods among which a
consumer is indifferent.
This figure illustrates a
consumer’s indifference curve.
At point C, Lisa consumes 2
movies and 6 six-packs a
month.

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Preferences and Indifference Curves
Lisa can sort all possible
combinations of goods into
three groups: preferred, not
preferred, and indifferent.
An indifference curve joins all
those points that Lisa says are
just as good as C.

G is such a point. Lisa is

indifferent between C and G.

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Preferences and Indifference Curves

All the points above the

indifference curve are preferred
to the points on the curve.

And all the points on the

indifference curve are
preferred to the points below
the curve.

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 Preferences and Indifference Curves

An indifference curve above I1

is I2 . All the points on I2 are
preferred to those on I1 .

For example, point J is

preferred to either point C or
point G.

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