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The Theory of Demand

Total utility curve .Basic assumption: consumer can rank market baskets (the most desired basket is ranked first) - .Indifference analysis .direct measuribility of utility Tools used: .Marginal utility curve immeasurability of utility Tools used: .Two major approaches to utility  KARDINAL  ORDINAL .

CARDINAL APPROACH TO UTILITY  Utility = satisfaction consumers receive from items they require. activities they engage in. or services they use  Total utility = total satisfaction enjoyed from consuming any given quantity  it´s a subjective concept  Marginal utility = the extra satisfaction a person receives over a given period by consuming one extra unit of a good .

The figure of total utility shows how the total utility depends on the amount of consumed good the ratio TU represents than the slope of total utility curve. Q .Relationship of Total and Marginal Utility Quantity of good consumed 0 1 2 Total utility 0 4 7 4 3 Marginal utility 3 4 5 9 10 10 2 1 0 MU  TU Q  The relationship between total and marginal utility can be expressed also graphically.

Relationship TU and MU graphically P MU TU0 MU Q0 Q .

your total utility will grow at a slower and slower rate . Gossen´s law The law of diminishing marginal utility – the amount of extra or marginal utility declines as a person consumes more and more of a good  Utility tends to increase as you consume more of a good.1. according to the law of diminishing marginal utility. however.

 Equilibrium amount of a good will be bought than. you presumably seek to obtain the greatest possible utility from your limited monthly income.  On condition we don´t have to pay anything for a good.Consumer Equilibrium  As a rational consumer. the equlibrium level of consumption of that good would be the amount that brings us the highest total utility. as long as the marginal utility equals the price of that product:  MU = P .

= equimarginal principle .. Gossen´s law The law of equal marginal utilities per dollar/euro.2. consumer must equalize the marginal utility per euro spent on each good MUx MUy (MU of income)  Px Py .to maximize utility.

therefore for each price exists the quantity demanded corresponding the consumer optimum  downwardsloping demand curve! . other things beings equal A higher price for a good reduces the consumer´s optimal consumption of that commodity.Deriving of demand curve The demand curve represents a relationship between the marginal utility of a good and the quantity consumed.

 The equation of budget line is: I  Px  X  Py  Y Y Px  X Py MRS XY  Y MUx  X MUy The slope: .ORDINAL APPROACH TO UTILITY  INDIFFERENCE CURVES  A graph of various market baskets that provide a consumer with equal utility  Different individual will naturally rank market baskets differently Main characteristics:   convex to origin – represents the „law of substitution“   downward-sloping   there is always an infinite number of curves   they never intersects mutually •  THE BUDGET CONSTRAINT  Budget line = represents all alternative combinations of two goods that consumer can afford considering his fixed income (assuming fixed prices).

Consumer equilibrium  Represents that combination of goods purchases that maximizes utility subject to the budget constraint  Geometrically. the equilibrium can be described as that combination of goods corresponding to the point at which the budget line is just tangent to the highest attainable indifference curve in the consumer´s indifference map Px MUx  substitution ratio  Py MUy .

Indifference analysis B TU=7 TU=5 TU=4 TU=2 TU=1 A .

DERIVING THE DEMAND CURVE  Kept other things constant. it will mean that the less of that product you can afford with your income  graphically it means the change of the budget line slope – it becomes steeper and therefore will touch different indifference curve (representing lower level of utility)  each price corresponds other optimal point and therefore different quantity of good demanded. in that way we can construct the demand curve (individual)  . when the price of X has increased.

we enjoy a surplus of utility on each of these earlier units . it is rooted in the law of diminishing marginal utility  we pay for each unit what the last unit is worth – but by the law of diminishing marginal utility the earlier units are worth more to us than the last thus.CONSUMER SURPLUS = the gap between the total utility of a good and its total market value  The surplus arises because we „receive more than we pay for“.

Consumer surplus P S P0 RZ D =M U Q Q0 .

Use the tools of indifference analysis.Tasks: 1. Your function of TU is: TU = 10X – X2 . Graphically show. how many units you will consume. 4. at what level of consumption start TU decrease? b) Derive and draw TU and MU curves. c) Assume Px = 6 Eur. b) Calculate. 2. Can be TU positive and MU negative at the same time? Draw graphs and explain. how high consumer surplus you´ll get. that the ratio MU/P for all other goods = 1)? . (where X is quantity of good consumed per week). By what level of consumption of good X will household maximize its utility. when the market price of good is 8 Eur and decide. a) Write the equation of MU and decide. Knowing following dates: a) Draw the graphs of TU and MU curves. Q TU 1 20 2 36 3 48 4 56 5 60 6 60 7 58 3. Px = 120 Eur and Py = 80 Eur. knowing. what will happen when Px has increased by 18 Eur and at the same time Py by 12 Eur.