Lecture notes for Business

Economics (BUS-704) - 3

- Dr. Mirza Azizul Islam

Demand and Consumer behavior (CH-5)
 In explaining consumer behavior, economics relies on
the fundamental principle that people tend to choose
those goods and services they value most highly – value
means utility or satisfaction – not measurable, but can be
still viewed as a construct to understand how rational
consumers divide their limited resources among the
commodities that provide them with maximum
satisfaction i.e. they prefer most – one bundle of good
yield greater satisfaction than another (ordinal utility) i.e.
preference ranking.
Q Total Marginal
Utility Utility

0 0

1 4 4

2 7 3

3 9 2
Marginal utility and the law of diminishing
marginal utility
 Total utility goes up but marginal utility goes
down i.e. Each additional unit consumed yields
less utility than the previous one i.e. Total utility
grows at a slower and slower rate – implies
marginal utility curve is downward sloping
 Total utility i.e. the sum of marginal utilities
Equi marginal principles
 Statesthat a consumer having fixed income and
facing fixed prices will achieve maximum
satisfaction when the marginal utility of the last
dollar spent on each good is the same. This can
be expressed mathematically

 As MU1/P1 = MU2/P2 ….. = MU per dollar of

income
Why demand curve slopes downward?
 Suppose P1 goes up, MU1/P1 goes down - lower the
consumption of good 1 which will raise the level of
MU1 till it becomes equal to other MUs/Ps
 MU1/P1 = 10/2 = 5
 MU2/P2 = 9/3 = 3
 So, increase consumption of 1, MU1 goes down say,
8/2 = 4
 Decrease consumption of 2, MU2 goes up say 12/3 =

4
Why demand curve slopes downward?

 P1 goes up i.e. MU1/P1 goes down

 Solower the consumption of 1 to raise MU1 till
new MU1/P1 equals MUs/Ps of all other goods-
 Meansthat when the price of a good rises,
consumption of that good falls.
Alternative approach
 Substitution effect
When the price of a good goes up, people substitute other
products in their consumption basket e.g. price of coffee goes
up, more of tea consumed and less of coffee i.e. coffee is
substituted by tea – therefore less of coffee consumed.
 Income effect

Price of coffee goes up, real income goes down, likely to buy
less of all goods including the one whose price has increased –
hence generally income effect reinforces the substitution effect
to produce downward sloping demand curve.
Definition of substitute and complements
 Goods A and B are substitutes if an increase in the price
of A increases the demand for good B – i.e. Demand
curve for good B shifts to the right as a result of
substitution in consumption.
 Goods A and B are complements if an increase in the
price A leads to a decrease in the demand for good B as a
result consumption of ‘B’ being complementary to
consumption of good A.
 In between are independent goods where the price
change of one good is unlikely to have any effect on the
other