Consumer Behavior and Demand Analysis

Consumer Behavior
Any market has two sides:  The demand: resulting from the behavior of the buyers in the market;  and the supply: resulting from the behavior of the sellers in the market.  The behavior of either side can be described with appropriate curves: – The Demand Curve and the Supply Curve.  Why do people demand goods and services?
• •

Receive satisfaction or pleasure from consuming the good. Economists terms this satisfaction utility

Consumer


 

Our basic assumptions about a “rational” consumer: Consumers are utility maximizers Consumers prefer more of a good (thing) to less of it. Facing choices X and Y, a consumer would either prefer X to Y or Y to X, or would be indifferent between them. Transitivity: If a consumer prefers X to Y and Y to Z, we conclude he/she prefers X to Z Diminishing marginal utility: As more and more of good is consumed by a consumer, ceteris paribus, beyond a certain point the utility of each additional unit starts to fall.

however. Consumers’ choices are constrained by their incomes. cannot have every thing they wish to have. Within the limits of their incomes.Utility The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice. consumers make their consumption choices by evaluating and comparing consumer goods with regard to their “utilities.  In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called “utility”. Consumers.”   .

Approaches to consumer behavior  Cardinal Approach    Traditional theory (By Marshall) Examines consumer behavior on the basis of utility consideration. Utility in terms of number Revealed preference theory Modern Theory (Hicks) Ranking of options for a particular commodity Indifference Curve Analysis  Ordinal approach     .

the Marginal Utility eventually starts declining.Cardinal Approach  Law of Diminishing marginal Utility   Other things remain the same. If MU diminishes then demand will also decrease. as a consumer increases his consumption of goods. .

It is the sum of marginal utilities. •  MU = DTU / D Q consumed of a good . (This could be many units of a good) Marginal Utility (MU) .the change in total utility when consumption of a good changes by one unit. MU and profit  Total Utility (TU) .relates consumption of a good to the utility derived from consuming a good.TU.

Utility Schedule Quantity 2 3 4 5 6 Total Utility 8 18 26 31 33 Marginal Utility 0 10 8 5 2 7 8 33 32 0 -1 .

Diagram of TU and MU 35 30 25 TU and MU 20 15 10 5 0 -5 Quantity Marginal Utility Total Utility .

In fact. consumers compare the (expected) utility derived from one additional money spent on one good to the utility derived from one additional money spent on another good.    Some facts of life: Limited income Opportunity cost of making a choice: Buying a unit will leave the consumer with less money to buy other things. .

Findings   Shape of MU Eventually downward sloping • Law of diminishing marginal utility  Positive always • Rational behavior  Consumer only purchases a good if they get some positive utility from it. .

Findings contd…   Shape of TU Positive slope • Consumer only purchases a good if gets some positive amount of utility (rational behavior)  Slope gets flatter as Q increases  Law of diminishing marginal utility .

Consumer Surplus .the difference between the price buyers pay for a good and the maximum amount they would have paid for the good.Consumer surplus  Money measure of the value the consumers get from a good or service. Example: •   • • I’m willing to pay $6 for a case of soda Soda is on sale for $5 a case Consumer surplus = $1 . net of the amount paid.

Consumer surplus P $9 This is the Consumer Surplus for the second case of soda S $7 $5 D 0 1 2 3 Q .

 Curves further from origin represent higher utility levels .Ordinal utility Indifference Curve  A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

That is utility is compared but not qualified. The combinations between two tested sets are given. This is called the scale of preference. . 2. Convexity: A convex indifference curve represents the consumer behavior. 3. Ordinality: The indifference curve analysis considers ordinal measure of utility. 4. The consumer always prefers higher satisfaction to lower. 2. Scale of preference: On a series of indifference curves the consumer has a preference increases from low to high. Rationality: The consumer is rational.Assumptions of Indifference curve Indifference curve analysis is based on the following assumptions: 1. He always prefers higher satisfaction to the lower and he knows all the combinations giving him same satisfaction or different satisfactions. The convex IC shows the utility behavior with out actually measuring utility in cardinal terms. Transitivity: It is assumed that the combinations are continuous to form a curve.

Properties of Indifference curve  Indifference curve towards axis represents lower level of satisfaction .

Properties.  Indifference curve never touches the axis ....

 IC is a downward sloping curve .

 On a IC Marginal rate of substitution decreases .

 IC is convex to the origin .

  IC curves need not to be parallel IC curves do not intersect. .

Combinations 1 2 3

Mangoes 10 8 6

Oranges 2 3 4

4
5

4
2

5
6

Budget line

The amount of goods a consumer can buy is constrained by the income. This budgetary constraint can be shown by the budget line.

A (Pm*Qm) 20*5 20*4 20*3

B (Po*Qo) 10*0 10*1 10*2

A+B (Total Income) 100 100 100

20*2
20*1

10*3
10*4

100
100

It is case of optimizing satisfaction. In the diagram E2 is necessary condition. There are two conditions of consumer equilibrium a. Yet it is not the equilibrium. b. In the diagram is a necessary condition. Necessary Condition: Tangency is a necessary condition. It fulfills tangency as well as convexity. Tangency represents mathematical optimization and convexity denotes consumer behavior.Consumer equillibrium The consumer is in the equilibrium where the indifference curve is tangent to the budget line. . Sufficient condition: Tangency + convexity is sufficient condition.

Consumer surplus  Anything above the consumer equilibrium but with in the budget line is consumer surplus. .

DEMAND ANALYSIS .

¨The demand curve is just the description of the relationship between quantity and price. at different prices. during a specific time period. there is no demand.Demand defined  Demand is the willingness and ability of buyers to purchase different quantities of a good. Both willingness and ability must be present. if either is missing.   .

Determinants of Demand      Income Preferences Prices of related goods Number of buyers Future price .

. If demand does not change even though income does. If income and demand go in opposite directions. If a person’s income and demand change in the same direction. he or she may buy more or less of a certain good. the good is an inferior good. the good is a normal good. the good is a neutral good.Income     As a person’s income changes.

.Preferences  Changes in preferences cause changes in demand.

the demand for one moves in the opposite direction of the price of the other.  If the price of coffee increases. the demand for tennis balls decreases.  When two goods are complements. the demand for tea increases as people substitute tea for the higher-priced coffee.Prices of Related Goods  When two goods are substitutes. the demand for one moves in the same direction as the price of the other. .  As the price of tennis rackets rises.

Number of Buyers  A change in the number of buyers. can change demand. . either an increase or a decrease.

Future Price   Buyer’s expectations of future prices can cause them to buy now or wait to buy. The only factor that affects quantity demanded is price. . Both actions affect current demand.

A matter of time Some elasticity estimates.Other determinants     Availability of substitutes Share of consumer’s budget spent on the good. .

It is expressed in the form of a linear demand equation. or an equation that shows how quantity demanded is related to product price. . holding constant the five other variables that influence demand. graph. holding all other variables constant. A demand function can be expressed as:   Which means that the quantity demanded is a function of the price of the good.Demand Function   A table.

Demand function contd…  Where      Q = Quantity purchased of a good or service P = Price of the good or service M = Consumer’s income Pr = Prices of related goods N = Number of buyers .

the smaller the quantity demanded. all other things being equal. the higher the price. If P ↑ then Qd ↓ If P ↓ then Qd ↑   .Law of demand  The quantity purchased of a good or service is inversely related to the price. Thus.

Demand  Quantity demanded The quantities of a good or service that people will purchase at a specific price over a given period of time  Demand Graph of the total quantities of a good or service that purchasers will buy at different prices at a given time .Quantity Demanded vs.

Types of Demand  Individual demand The quantity of a good or service that an individual or firm stands ready to buy at various prices at a given time  Market demand The sum of the individual demands in the marketplace .

05 0 1 2 3 4 5 6 7 8 9 10 11 12 13 D Quantity (Number of hours per Day ) .45 1.20 1.15 1.35 Price per Hour 1.55 1.40 1.50 1.25 1.30 1.Demand Curve AED 1.10 1.

Demand Schedule Price Quantity Demanded per Pizza per Week (millions) a b c d e $15 12 9 6 3 8 14 20 26 32 .

Demand Curve for Pizza $15 Price per pizza 12 a b c d e D 8 14 20 26 32 Millions of pizzas per week 9 6 3 0 .

Individual Demand for Pizzas A B C $12 Price 8 4 1 2 3 $12 8 4 $12 dH dB 8 4 1 dC 1 2 Pizzas (per week) .

Market Demand for Pizzas (d) Market demand for pizzas dH + dB + dC = D $12 Price 8 4 1 2 3 6 Pizzas (per week) .

Changes in Demand  Change in Quantity Demanded Movement along the demand curve that occurs because the price of the product has changed  Change in Demand Change in the amounts of the product that would be purchased at the same given prices. a shift in the entire demand curve .

(Change in Demand) . the demand curve shifts to the left. the Curve Shifts   When demand goes up.When Demand Changes. (Change in Demand) When demand goes down. the demand curve shifts to the right.

Elasticity of Demand .

It measures how a price change affects the quantity of a particular good that people want to buy. .What is Elasticity of Demand?   Elasticity is another term in economics that sounds more difficult to understand than it really is.

 Elastic: a price change has a significant impact on the quantity demanded.  Unit-elastic: the impact of a price change is neutral – that is. or unit-elastic. inelastic.  Inelastic: there is a minor change in quantity demanded when the price changes. neither major nor minor.What types of elasticity are there? Demand for a good can be elastic. .

When we divide the percentage change in quantity demanded by the percentage change in price. we get a number that is greater than 1.How do we find out which type of demand is at work?   In all cases. or exactly 1. . the type of demand has to do with the relationship between the percentage change in quantity demanded and the percentage change in price. less than 1.

Elasticity of demand = Percentage change in quantity demanded Percentage change in price .Computing the Elasticity of Demand  Elasticity of demand measures the percentage change in quantity demanded divided by percentage change in price.

If the answer is less than 1. If the answer is exactly 1. the demand is inelastic. .)    If the answer to our division problem is greater than 1. the demand is elastic.How do we find out which type of demand is at work? (cont. the demand is unitelastic.

The vertical demand curve is mythical as the substitution and income effects prevent this from happening in the real world. • Relatively inelastic: A percent increase in price results in a smaller % reduction in sales. (b) Demand for Cigarettes Quantity/ time . The demand for cigarettes has been estimated to be highly inelastic.Elasticity of Demand Mythical demand curve (a) Quantity/ time • Perfectly inelastic: An increase in price results in no change in consumers purchases.

. Sales revenue (price times quantity) is constant. A decreasing slope results.Elasticity of Demand Demand curve of unitary elasticity (c) Quantity/ time • Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price.

Example :1  Suppose the quantity demanded goes down by 15 percent and the price goes up by 10 percent.5. the demand is elastic. Since the number is greater than one. What type of demand do we have? We divide 15 percent by 10 percent and get 1.  .

5.Example: 2  What if the quantity demanded goes down by 5 percent and the price goes up by 10 percent? We divide 5 percent by 10 percent and get 0. Since the answer is less than 1. the demand is inelastic.  .

Obviously 1 is equal to 1.Example: 3  What if the quantity demanded goes down by 10 percent and the price goes up by 10 percent? We divide 10 percent by 10 percent and get 1.  . so the demand is unit-elastic.

.Price elasticity of demand  Price elasticity reveals the responsiveness of the amount purchased to a change in price.

or put more simply - (Q0  Q1 ) (Q0  Q 1) = ( P0  P1 ) ( P0  P1) .Price Elasticity of Demand  Price elasticity reveals the responsiveness of the amount purchased to a change in price. Price Elasticity of demand % Change in quantity demanded = % Change in Price = %D Q %D P (Q0  Q1 ) = (Q0  Q1 ) 2 ( P0  P ) 1 ( P0  P ) 2 1 .

5 .33 % quantity demanded: (50  70 ) 2 60 Percent change in price: ( 7  6) 1   15 . She can sell 50 specialty cakes per week at $7 a cake. What is the demand elasticity for Trina’s cakes? (50  70 )  20 Percent change in   33 .Recall Price Elasticity of demand = (Q0  Q1 ) (Q0  Q1 ) 2 ( P0  P ) 1 ( P0  P ) 2 1 .Price Elasticity Numerical Application   Suppose Trina bakes specialty cakes.38 % (7  6) 2 6. or 70 specialty cakes per week at $6 a cake.

. The greater the availability of substitutes. demand is more elastic. the more elastic demand will be.  Share of total budget expended on product  As the share of the total budget spent on the product increases.Determinants of Price Elasticity of Demand  Availability of substitutes   When good substitutes for a product are available. a rise in price induces many consumers to switch to another product.

Time and Demand Elasticity  If the price of a product increases. This relationship is sometimes referred to as the second law of demand. demand for most products will be more elastic in the long run than in the short run. . consumers will reduce their consumption by a larger amount in the long run than in the short run.   Thus.

Income Elasticity of demand = % Change in quantity demanded % Change in Income  A normal good is a good with a positive income elasticity of demand.  As income expands.Income Elasticity  Income elasticity indicates the responsiveness of a product’s demand to a change in income. . the demand for inferior goods will decline.  As income expands.  Goods with a negative income elasticity are called inferior goods. the demand for normal goods will rise.

What Determines Elasticity of Demand?      Four factors affect the elasticity of demand: Number of substitutes Luxuries versus necessities Percentage of income spent on the good Time .

the demand for the good is likely to be inelastic.Number of Substitutes  When there are few substitutes for a good. Therefore. . the opposite is true: the demand tends to be elastic. When there are many substitutes for a good. the quantity demanded is unlikely to change much if the price rises.

Luxuries versus Necessities   Demand for necessities tends to be inelastic because people need those goods even if prices rise. . Demand for luxuries tends to be elastic because people will often do without those goods if prices rise.

demand for it tends to be elastic.Percentage of Income Spent on the Good   If a good requires a large percentage of a person’s income. Demand for goods that require a small percentage of a person’s income tends to be inelastic. .

. demand is usually elastic.Time  When consumers have little time to respond to a price change. When they have more time to respond. demand is usually inelastic.

Inelastic demand and an increase in price lead to an increase in total revenue. Inelastic demand and a decrease in price lead to a decrease in total revenue.Relationship Between Elasticity and Revenue     Elastic demand and an increase in price lead to a decrease in total revenue. Elastic demand and a decrease in price lead to an increase in total revenue. .

Demand Estimation and Forecasting .

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