Business Economics: Lecture 1

1. Utility
 Economics believes individuals act as if they are maximizing their UTILITY FUNCTION U ( ⋅ )
o U ( ⋅) attaches a number to everything: weather, wealth, banana, health, money.
 Options are constrained: budget, knowledge, legality, ability
 Different people have different utility functions
 Often we interpret utility = happiness/satisfaction.

1.2.Rationality
 Economists often assume people are "rational"
 This means that people
o have an opinion about everything
o act to maximize utility
o preferences are transitive:U ( A )> U ( B )and U ( B )> U ( C ) , then U ( A )> U ( C ) )
 Rationality does not mean that people are selfish, greedy, or stupid (although they might be.)

1.3.A typical utility function

Utility is an idea that people get a
1.3.1. Utility is INCREASING certain level of satisfaction/
 Utility U ( x ) is increasing in quantities happiness/ utility from consuming
o Assuming free disposal goods and service.
o eg: U ( 3 apples ) > U ( 2 apples )
 Marginal utility U ' ( x ) is positive  U ' ( x ) >0 Marginal utility is the change in
utility from consuming an
1.3.2. Utility is CONCAVE additional unit.
 Utility increases at a decreasing rate
Diminishing marginal utility  U ' ' ( x ) <0 Diminishing marginal utility
 Example: pizza... means that each additional unit of
o Initially you are hungry. 1st slice gives a lot of utility. a good adds less to utility than the
o Then you' re less hungry. The 2nd slice gives some extra utility but previous unit.
not much...
o The 10th slices give almost zero utility
 When is utility decreasing? Is marginal utility ever negative?

Question
 x=¿ amount of pizza consumed
−π
 Your utility for pizza is U ( x )= ( x−α )2
2
 How much pizza should you consume? x=α

Summary
 Individuals act as if they are maximizing a utility function
 Maximization is subject to constraints (budget, information, ability)
 We usually assume utility is increasing and concave.

1.4.Utility and price

 One way to measure utility is to give the utility a monetary value.
 Example: if I would pay £0.90 for a slice, we can say the utility is at
least £0.90
 In the above example, if a piece of cake cost £0.90, it would make
sense to consume two pieces.
 The 1st piece gives 120p of utility –greater than the price of 90p.
 The 2nd piece gives a utility equal to the price.
 The 3rd piece would give marginal utility of only 60p – which is less than the price of 90p

1.5.The optimum level of consumption

 For one good, the optimum level of consumption would be to consume a quantity of the good up to the point where
MU = Price.
 There’s no point paying 75p for cake if it only gives us 50p worth of utility.

1.6.Demand curve and Marginal Utility

 Our demand curve is derived from our marginal utility.
 If a good gives us more satisfaction, e.g. it becomes more fashionable, our MU + demand curve will shift to the right.

2. Consumer Theory

2.1.Choosing how much to buy

In the real world, we are not just deciding how much of one good to buy. We are also deciding how to choose between
different combinations of goods.

Suppose only 2 goods exist:  Total utility = utility from apples + utility from oranges
apples with a price pa U ( x a , x o ) =U a ( x a ) +U o ( x o )
oranges with a price po  Assume utility is increasing and concave in ( x a , x o )
x a=¿ number of apples  What should you buy?
bought
x o=¿ number of oranges
bought
Budget is K 2.2.Budget Constraints
 There is a budget constraint: we can only spend K
 Total budget 2: amount spend on apples + amount spend on oranges
K ≥ x o po−x a pa
 So, the problem becomes: choose x a , x o …
o …to maximize utility U a ( x a ) +U o ( x o )
o …subject to the budget constraint K ≥ x o po−x a pa

2.3.Walra’s Law - Spend everything!

 You should spend the entire budget. Why? Is this true in real life? No.
o there are only 2 goods Walra’s doesn’t account for
o utility increasing in x a , x o savings.
o there is no point in saving because there is nothing else to buy Lagrangian will account for
 Budget = money spent on oranges + money spent on apples: the utility of saving!
K= xo po −x a pa

2.4.First Order Conditions

 The Lagrangian for this problem is
L=U a ( x a ) +U o ( xo )+ λ ( K−x o po−x a pa )
¿ ¿
 The optimal choices are x o=x and x a=x a:
o
 First Order Conditions (FOC) are:
∂L
=U 'a ( x ¿a ) −λ pa =0 ¿ ¿
∂ xa Solvable: 2 unknowns ( x a , x o )
∂L and 2 equations
=U 'o ( x¿o ) −λ po =0 K ≥ x o po−x a pa
∂ xo
U 'a ( x ¿a ) U 'o ( x¿o )
=
pa po
 Combine the two FOCS to obtain:
U 'a ( x ¿a ) U 'o ( x¿o )
=
pa po

2.5.Optimal Consumption Rule

 If the choice is optimal, MU per £ must be equal for the two goods
MU a MU o
=
pa po
 If the choice is optimal, marginal benefit of an apple = marginal opportunity cost.
 ACCOUNTING COST of an apple is pa.
 OPPORTUNITY COST of an apple is the utility of the oranges that you could buy instead.

Optimal consumption rule:

to maximize utility, a
consumer should allocate
spending so that the
marginal utility per pound
is equal for all purchases.

Opportunity cost: the

benefit foregone from the
next best alternative.

 Intuitively, if the MU per £ of apples is higher than the marginal utility per dollar of oranges, then the consumer gets
more “bang from a buck” spent on apples than on oranges. And vice versa…
MU a MU o
If > , then buy more apples and fewer oranges.
pa po
MU a MU o
If < , then buy fewer apples and more oranges.
pa po

 If prices change... Higher pa: apples now provide less utility per £
o consumer buys fewer apples...
o ...and more oranges (to spend all her budget).

2.6.Numerical example: Cobb-Douglas utility

1 3
 Utility is U ( x 1 , x 2 )= ln ( x 1 ) + ln ( x 2 )
4 4
 Budget is K=10
 Walra’s Law: p1 x 1 + p2 x 2=10
 The Lagrangean is
1 3
L= ln ( x 1 ) + ln ( x2 )+ λ ( 10−x 1 p 1−x 2 p2 )
4 4
 FOCS are
∂L 1 1 1 3
= −λ p1=0
∂ x1 4 x1 4 x1 4 x2 x 2 p2
λ= = → =3
∂L 3 1 p1 p2 x 1 p1
= −λ p2=0
∂ x1 4 x2
 From the budget constraint, p1 x 1 + p2 x 2=10
10 30
4 p 1 x 1=1 0 → p1 x1= → x 2 p2 =
4 4
 Therefore if we now the price of each good we can find the optimum purchasing amounts

Question
2 Buying blue balloons will
 Utility function is U ( x R , x B ) =√ x R− ( x B ) decrease the utility function,
o x R ≥ 0 is the number of RED balloons therefor x B =0 to maximise
o x B ≥ 0 is the number of BLUE balloons the utility function wrt x B .
 Your budget is K=£ 1
 Price of BLUE balloons is pB =¿ $0.17
 You buy 99 red balloons x R =¿ 99
 What is the price of red balloons?
 x B =0 → Utility is U ( x R , x B ) =√ x R
 Walra’s Law: x R p R=1 → p R=1 /99=¿ $0.01

Summary
 It is optimal to "spend" your whole budget (possibly on "savings")
 If a decision is optimal, then
U 'a U 'o
=
pa po

3. Demand

3.1.Demand A demand curve is a function that

 The demand curve is a way to understand the decisions of many shows the quantity demanded at
consumers jointly. It is derived from the marginal utility. different prices.
 Quantity demandedQ : quantity bought by all consumers at a given price
 Demand CURVE: a FUNCTION of price, Q=D ( p ) The quantity demanded is the
o relationship between quantity demanded and price quantity that buyers (consumers) are
o other things are assumed constant (incomes, weather, taxes, willing and able to buy at a particular
etc.) price.

3.2.The law of demand

law of demand = a law stating that
there is a negative causal relationship
between price (P) and quantity (Q) of
a good demanded: the higher the
price, the lower the quantity
demanded; the lower the price, the
greater the quantity demanded. The
law of demand is illustrated by the
demand curve, which is downward
sloping.
 The Law of Demand: Other things being equal, demand slopes down
 For two reasons:
o Substitution effect
 Other goods are better value if price increases
 If apples become more expensive: buy fewer apples and more oranges
o Income effect
 If the price of the things you are buying goes up, you effectively have a smaller budget, so you buy
less

3.2.1. Inverse demand

 For direct demand Q=D ( p ) is direct demand, inverse demand is p=P ( q ), where q is quantity, p is price
a− p
 Example: Direct demand is Q ( p )=
b
Inverse Demand is P ( q ) =a−bq

Reading a Demand Curve in Two

Different Ways:
Horizontal Reading: P=$20 per barrel,
buyers are willing to buy 25 million
barrels of oil per day.
Vertical Reading: The maximum price
that demanders are willing to pay to
purchase 25 million barrels of oil per
day is P=$20 per barrel.

3.2.2. Distinguishing between movement along the supply curve and a shift in supply
 Movement along a demand curve (change in Q supplied): A movement along the demand curve for a good can be
caused only by a change in the price of the good.
 Shift of a demand curve (change in demand) A shift of the demand curve for a good are caused only by a change in
any of the non-price determinants of demand.
o A rightward shift indicates an increase in demand
o A leftward shift indicates a decrease in demand.
3.2.3.Non-price determinants of demand (causes of demand curve shifts)
Demand curve can shift in response to:

 Changes in income - the effects on D depend on whether the good is:

o Normal = demand for the good increases with increasing consumer income; most goods are normal: as
income rises, D increases (shifts right); as income falls, D falls (shifts left)
o Inferior = demand for the good decreases with increasing consumer income; ex lower-price goods like used
cars, used clothes, margarine (as opposed to butter): as income rises, D falls (shifts left); as income falls, D
increases shifts right

 Changes in the number of buyers (demographic changes): If the number of buyers in a market increases, D increases
(shifts right); if the number of bu ers decreases, D decreases shifts left

 Changes in prices of related goods: The effects on D depend on whether the related goods are:
o substitutes= goods that satisfy a similar need, ex meat and fish; as P of good A (ex meat) increases, D for
good B (ex fish) increases (shifts right}; as P of good A falls, D for good B falls (shifts left)
o complements = goods that are used together, ex tennis balls and tennis rackets; as P of good A increases, D
for good B decreases (shifts left ; as P of ood A decreases, D for ood B increases shifts ri ht

 Changes in expectations: (buy less now if you think it's going to get cheaper in the future)
Eg. the expectation of a reduction in future oil supply increases the demand for oil today.

 Changes in tastes and preferences: When tastes and preferences of consumers change in favor of a good, D
increases (shifts right); if references change against a good, D decreases shifts left

4. Price elasticity of demand (PED) The elasticity of demand

measures how responsive the
We measure the responsiveness of demand to price using the elasticity of quantity demanded is to a
demand. change in price; more responsive
ⅆQ equals more elastic.
×100
% change ∈quantity demanded Q ⅆQ P
ϵ D= = =
% change ∈ price ⅆP ⅆP Q
×100
P
 Law of demand: ϵ D < 0, in practice, ϵ D is treated as
positive |ϵ D| (absolute value) .
 Elasticity is "unit-free" (not influenced by currency, etc.)

4.1. Price elastic and price inelastic demand

 Elastic demand: |ϵ D| > 1
 Inelastic demand:|ϵ D| < 1
 Unit elastic demand: |ϵ D| = 1

 In a diagram with two intersecting D curves, the flatter

curve has the more elastic D for the same ΔP

4.2.Elasticity of linear demand

 Linear Inverse Demand: P ( q ) =a−bq.
a− p
 Direct demand: Q ( p )= .
b
 ⅆQ P −1 p −p
ϵ D= = =
ⅆP Q b a− p a− p
b
 Elasticity depends on price and can vary along the demand curve.

4.3.The determinants of Elasticity of demand

 Availability of substitutes: substitute goods = two or more goods that
satisfy a similar need.
The more close substitutes a good has, the more elastic its demand =
the greater its PED. Ex if P of apples increases consumers can switch
to other fruits (substitutes to apples)  high responsiveness (drop)
of Q of apples demanded. But if P of gasoline increases consumers
have few alternatives  low responsiveness (drop) of Q of gasoline
demanded.
ϵ D for goods with fewer and worst substitutes < ϵ D for goods with
more and better substitutes
o Cadbury's Dairy Milk is elastic
o Chocolate in general is inelastic

 Degree of necessity: necessity = a good that is necessary to a consumer (to be contrasted with a luxury = a good that
is not essential)
The more necessary a good, the less elastic its demand = the lower its PED. Eg: food is a necessity people cannot live
without  if P of food increases, the Q of food demanded will drop by only a little.
ϵ D for necessities < ϵ D for luxuries.

 Timescale: The more time a consumer has available to make a decision to buy a good, the more elastic the demand.
Eg. if P of gasoline increase, over a short time there will be a small drop in Q demanded, but over longer periods
consumers can switch to other forms of transportation than cars or can buy more fuel-efficient cars  larger drop in
Q demanded.
Short run ϵ D < Long run ϵ D
o if price of gasoline goes up... short run: drive less… long run: buy a more efficient car
o Demand is more elastic in the LONG RUN than in the SHORT RUN

 Proportion of income is spent on the good: The greater the proportion of income spent on a good, the more elastic
its demand = the greater its PED. An increase in the P of big-ticket items will be felt more strongly by consumers
than an increase in the P of cheap item, leading to a greater responsiveness (drop) in the Q of big-ticket items.
ϵ D for cheap items < ϵ D for big-ticket items.

4.4.Demand elasticity and revenues

Total Revenue R=p ⋅ q ( p ) = a firm's total earnings from
selling its output. As p changes, R may increase, decrease
or stay unchanged, depend in on PED:

ⅆR ⅆq p ⅆq
ⅆp
=q + p =q 1+
ⅆp (
q ⅆp )
=q (1+ϵ D )

If price goes up...quantity falls ...

 If elastic demand ϵ D > 1,  ⅆR /ⅆp<0
Sinceⅆp> 0  ⅆR< 0 revenues fall
 If inelastic demand ϵ D < 1  ⅆR /ⅆp>0
Sinceⅆp> 0  ⅆR> 0 revenues rise
If price goes down...quantity increases ...
 If elastic demand ϵ D > 1,  ⅆR /ⅆp<0
Sinceⅆp< 0  ⅆR> 0 revenues rise
 If inelastic demand ϵ D < 1  ⅆR /ⅆp>0
Sinceⅆp< 0  ⅆR< 0 revenues fall

4.5.Cross-price elasticity of demand

Cross-price elasticity of demand = responsiveness of demand for good A to changes in price of good B.
% change∈quantity demanded of A ⅆ Q A PB
ϵ A , B= =
% change∈ price of B ⅆ PB QA
 If ϵ A , B > 0  A and B are substitute goods
o ⅆ Q A and ⅆ PB change in the same direction
o If P of Margarine increases,Q demanded for margarine will decrease, Q demanded for butter will increase
 ϵ
If A , B < 0  A and B are complementary goods
o ⅆ Q A and ⅆ PB change in the opposite directions
o If P of printers increases, Q demanded for printers will decrease, Q demanded for cartridges will decrease

4.6.Income elasticity of demand

Cross-price elasticity of demand = responsiveness of demand for good A to changes in income.
% change ∈quantity demanded of A ⅆ Q A I
ϵ I= =
% change ∈income ⅆ I QA
ϵ I can be used to distinguish between two different sets of goods:
 If ϵ I is positive or negative
o ϵ I > 0  A is a normal good: ⅆ Q A andⅆI change in the same direction
o ϵ I < 0  A is an inferior good: ⅆ Q A andⅆI change in the opposite direction
ϵ
 If I is less than or greater than one
o ϵ I > 1  A is a luxury
o ϵ I < 1  A is a necessity

Question
π
 Consider this demand curve: Q ( p )=K p α . What is the elasticity of this demand curve at price p= ?
3
ⅆQ P p
 ϵ D=
ⅆP Q ( )
= ( αK pα −1 )
K pα
=α

Summary
 Demand is the optimal response of consumers to price
 Demand slopes down
 We measure the responsiveness of demand using elasticities
o own-price elasticity
o cross price elasticity
o income elasticity