Background to Demand

Background to Demand

Marginal Utility Theory

MARGINAL UTILITY THEORY

Total and marginal utility

meaning

of total utility

marginal

utility: TU/Q
marginal utility

diminishing

total

and marginal utility curves

Darrens utility from consuming crisps (daily)

16 14 12

Utility (utils)

10 8 6 4 2 0 0 -2 1 2 3 4

Packets of crisps 0 1 2 3 4 5 6

TU in utils 0 7 11 13 14 14 13

Packets of crisps consumed (per day)

Darrens utility from consuming crisps (daily)

16 14 12

TU
Packets of crisps 0 1 2 3 4 5 6 TU in utils 0 7 11 13 14 14 13

Utility (utils)

10 8 6 4 2 0 0 -2 1 2 3 4

Packets of crisps consumed (per day)

Darrens utility from consuming crisps (daily)

16 14 12

TU
MU Packets TU of crisps in utils in utils 0 1 2 3 4 5 6 0 7 11 13 14 14 13 7 4 2 1 0 -1

Utility (utils)

10 8 6 4 2 0 0 -2 1 2 3 4 5

Packets of crisps consumed (per day)

Darrens utility from consuming crisps (daily)

16 14 12

TU
MU Packets TU of crisps in utils in utils 0 1 2 3 4 5 6 0 7 11 13 14 14 13 7 4 2 1 0 -1

Utility (utils)

10 8 6 4 2 0 0 -2 1 2 3 4 5

MU

Packets of crisps consumed (per day)

Darrens utility from consuming crisps (daily)

16 14 12

TU
TU = 2 Q = 1

Utility (utils)

10 8 6 4 2 0 0 -2 1 2

MU = TU / Q

MU

Packets of crisps consumed (per day)

Darrens utility from consuming crisps (daily)

16 14 12

TU
TU = 2 Q = 1

Utility (utils)

10 8 6 4 2 0 0 -2 1 2

MU = TU / Q = 2/1 = 2

MU

Packets of crisps consumed (per day)

MARGINAL UTILITY THEORY

The optimum level of consumption: the onecommodity version

consumer surplus (total and marginal)

marginal
total

consumer surplus: MU P

consumer surplus: TU TE

Consumer surplus
MU, P

P1

MU

Q1

Consumer surplus
MU, P

P1

Total consumer expenditure

O Q1

MU

Consumer surplus
MU, P

P1

Total consumer surplus

Total consumer expenditure

O Q1

MU

MARGINAL UTILITY THEORY

The optimum level of consumption: the onecommodity version

consumer surplus (total and marginal)

marginal total

consumer surplus: MU P

consumer surplus: TU TE

maximising consumer surplus: P = MU

Marginal utility and the demand curve

Deriving an individual persons demand curve

MU, P

P1

Consumption at Q1 where P1 = MU

MU = D

Q1

Deriving an individual persons demand curve

MU, P

P1 P2

Consumption at Q2 where P2 = MU

MU = D

Q1

Q2

Deriving an individual persons demand curve

MU, P

P1 P2 P3

Consumption at Q3 where P3 = MU

b c

MU = D

Q1

Q2

Q3

MARGINAL UTILITY THEORY

Limitations of the one-commodity version

marginal marginal

utility affected by consumption of other goods utility of money not constant

Optimum combination of goods

the

equi-marginal principle
a demand curve

MUA/MUB = PA/PB
deriving

Background to Demand

Risk, Uncertainty and Insurance

RISK, UNCERTAINTY AND INSURANCE

Demand under conditions of risk and uncertainty

defining types risk

risk and uncertainty

of odds

attitudes

Diminishing marginal utility of income and attitudes towards risk taking

Total utility of income

TU

Total utility

U1

5000

10 000

15 000

Income ()

Total utility of income

TU
U2 Total utility b

U1

5000

10 000

15 000

Income ()

Total utility of income

c b

TU

U3 U2 Total utility

U1

5000

10 000

15 000

Income ()

Total utility of income

c b d a

TU

U3 U2 U4 U1

Total utility

5000

8000 10 000

15 000

Income ()

RISK, UNCERTAINTY AND INSURANCE

Insurance: a way of removing risks

How insurers spread risks
the

law of large numbers of the independence of risks

importance

Problems for insurers

adverse moral

selection

hazard

Background to Demand

Indifference Analysis

INDIFFERENCE ANALYSIS

Indifference curves
constructing

an indifference curve

Constructing an indifference curve

Pears Oranges Point 30 24 20 14 10 8 6 6 7 8 10 13 15 20 a b c d e f g

Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges

Constructing an indifference curve

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12
Pears Oranges Point 30 24 20 14 10 8 6 6 7 8 10 13 15 20 a b c d e f g

Pears

14

16

18

20

22

Oranges

Constructing an indifference curve

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6

a
Pears Oranges Point 30 24 20 14 10 8 6 6 7 8 10 13 15 20 a b c d e f g

Pears

10

12

14

16

18

20

22

Oranges

Constructing an indifference curve

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6

a
Pears Oranges Point

Pears

30 24 20 14 10 8 6

6 7 8 10 13 15 20

a b c d e f g

10

12

14

16

18

20

22

Oranges

Constructing an indifference curve

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6

a
Pears Oranges Point

b c

Pears

30 24 20 14 10 8 6

6 7 8 10 13 15 20

a b c d e f g

e f g

10

12

14

16

18

20

22

Oranges

INDIFFERENCE ANALYSIS

Indifference curves
constructing the

an indifference curve

shape of an indifference curve marginal rate of substitution

diminishing

Deriving the marginal rate of substitution (MRS)

30

a Y = 4 MRS = 4 b

26

X = 1 Units of good Y
20

MRS = Y/X

10

0 0
67

10

20

Units of good X

Deriving the marginal rate of substitution (MRS)

30

a Y = 4 MRS = 4 b

26

X = 1 Units of good Y
20

MRS = Y/X

10
9

Y = 1 X = 1

MRS = 1 d

0 0
67 1 14 3 Units of good X

10

20

INDIFFERENCE ANALYSIS

Indifference curves
constructing the

an indifference curve

shape of an indifference curve marginal rate of substitution

diminishing an

indifference map

An indifference map
30

Units of good Y

20

10

I5 I2
20

I3

I4

0 0 10

I1 Units of good X

INDIFFERENCE ANALYSIS

Indifference curves
constructing the

an indifference curve

shape of an indifference curve marginal rate of substitution

diminishing an

indifference map a budget line

The budget line

constructing

A budget line
Units of Units of good X good Y 0 5 10 15 30 20 10 0

Assumptions PX = 2 PY = 1 Budget = 30

A budget line
30

a
Units of Units of Point on good X good Y budget line

Units of good Y

20

0 5 10 15

30 20 10 0

10

Assumptions PX = 2 PY = 1 Budget = 30

0 0 5 10 15 20

Units of good X

A budget line
30

a
Units of Units of Point on good X good Y budget line

Units of good Y

20

0 5 10 15

30 20 10 0

a b

10

Assumptions PX = 2 PY = 1 Budget = 30

0 0 5 10 15 20

Units of good X

A budget line
30

a
Units of Units of Point on good X good Y budget line

Units of good Y

20

0 5 10 15

30 20 10 0

a b c

10

Assumptions PX = 2 PY = 1 Budget = 30

0 0 5 10 15 20

Units of good X

A budget line
30

a
Units of Units of Point on good X good Y budget line

Units of good Y

20

0 5 10 15

30 20 10 0

a b c d

10

Assumptions PX = 2 PY = 1 Budget = 30

0 0 5 10

d
15 20

Units of good X

INDIFFERENCE ANALYSIS

Indifference curves
constructing the

an indifference curve

shape of an indifference curve marginal rate of substitution

diminishing an

indifference map a budget line

The budget line

constructing effect

of a change in income

Effect of an increase in income on the budget line

40

30

Units of good Y

20
Assumptions

10

PX = 2 PY = 1 Budget = 30

0 0 5 10 15 20

Units of good X

Effect of an increase in income on the budget line

40
Assumptions PX = 2 PY = 1 Budget = 40

30

Units of good Y

20
1 6

n
m

10

Budget = 40
Budget = 30
0 5
7

0 10

15

20

Units of good X

INDIFFERENCE ANALYSIS

Indifference curves
constructing the

an indifference curve

shape of an indifference curve marginal rate of substitution

diminishing an

indifference map a budget line

The budget line

constructing effect effect

of a change in income of a change in price

Effect on the budget line of a fall in the price of good X

30
Assumptions PX = 2 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10 15 20 25 30

Units of good X

Effect on the budget line of a fall in the price of good X

30
Assumptions PX = 2 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10 15 20 25 30

Units of good X

Effect on the budget line of a fall in the price of good X

30
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10 15 20 25 30

Units of good X

Effect on the budget line of a fall in the price of good X

30

a
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

10

B
1

B2 b
c
20 25 30

0 0 5 10

15

Units of good X

INDIFFERENCE ANALYSIS

The optimum consumption point

Finding the optimum consumption

Units of good Y O

Units of good X

Finding the optimum consumption

Units of good Y

I5 I2

I3

I4

I1 O

Units of good X

Finding the optimum consumption

Units of good Y

Budget line

I5 I2

I3

I4

I1 O

Units of good X

Finding the optimum consumption

r s Units of good Y

Y1

u v I1 O X1 I2

I5

I3

I4

Units of good X

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

Finding the optimum consumption

r s Units of good Y

Y1

u v I1 O X1 I2

I5

I3

I4

Units of good X

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

The effect of a change in income

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

The effect of a change in income

the

incomeconsumption curve

Effect on consumption of a change in income

Units of good Y

B1 O

I1

Units of good X

Effect on consumption of a change in income

Units of good Y

B1 O

B2

I1

I2

Units of good X

Effect on consumption of a change in income

Units of good Y

I4 I3 B1 O B2 B3 B4 I1 I2

Units of good X

Effect on consumption of a change in income

Units of good Y

Income-consumption curve

I4 I3 B1 O B2 B3 B4 I1 I2

Units of good X

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

The effect of a change in income

the the

incomeconsumption curve Engel curve

Deriving an Engel curve from an income-consumption curve

Bread

I3 B1 B2 I1 I2 B3

CDs

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve I3 B1 B2 I1 I2 B3

CDs

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve I3 B1 B2 I1 I2 B3

CDs Income ()

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve

Qb
1

a
I3 B1 Qcd1 B2 I1 I2 B3

CDs

Income ()

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve

Qb
1

a
I3 B1 Qcd1 B2 I1 I2 B3

CDs

Income ()

Y1

Qcd1

Deriving an Engel curve from an income-consumption curve

Bread

Qb Qb 2
1

Income-consumption curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2

CDs

Income ()

Y2 Y1

b a

Qcd1Qcd2

Deriving an Engel curve from an income-consumption curve

Bread

Qb 3 Qb Qb 2
1

Income-consumption c curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2 Qcd3

CDs

Income ()

Y3 Y2 Y1

c
b a

Qcd1Qcd2Qcd3

Deriving an Engel curve from an income-consumption curve

Bread

Qb 3 Qb Qb 2
1

Income-consumption c curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2 Qcd3

CDs
Engel curve

Income ()

Y3 Y2 Y1

c
b a

Qcd1Qcd2Qcd3

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

The effect of a change in income

the the

incomeconsumption curve Engel curve

income

elasticity of demand and the income consumption curve

Deriving an Engel curve from an income-consumption curve

Bread

Qb 3 Qb Qb 2
1

Income-consumption c curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2 Qcd3

CDs
Engel curve

Income ()

Y3 Y2 Y1

c
b a

Qcd1Qcd2Qcd3

INDIFFERENCE ANALYSIS

The optimum consumption point

equating

the marginal rate of substitution with the price ratio

MRS = MUA/MUB = PA/PB

The effect of a change in income

the the

incomeconsumption curve Engel curve

income the

elasticity of demand and the income consumption curve effect of a rise in income on the demand for an inferior good

Effect of a rise in income on the demand for an inferior good

Units of good Y (normal good)

a B O
1

I1

Units of good X (inferior good)

Effect of a rise in income on the demand for an inferior good

Units of good Y (normal good)

I2

a B O
1

I1

B
2

Units of good X (inferior good)

Effect of a rise in income on the demand for an inferior good

Income-consumption curve
Units of good Y (normal good) b

I2

a B O
1

I1

B
2

Units of good X (inferior good)

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

Effect of a fall in the price of good X

30
Assumptions PX = 2 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10 15 20 25 30

Units of good X

Effect of a fall in the price of good X

30
Assumptions PX = 2 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10

B1
15 20 25

I1
30

Units of good X

Effect of a fall in the price of good X

30
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10

B1
15 20 25

I1
30

Units of good X

Effect of a fall in the price of good X

30

a
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

k j

10

I2

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

Effect of a fall in the price of good X

30

Units of good Y

20

Price-consumption curve

k j

10

I2

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

deriving

the individual's demand curve

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

B1

I1

Units of good X

Deriving a demand curve from a price-consumption curve

Fall in the price of X a b

Expenditure on all other goods

B1

B2

I1

I2

Units of good X

Deriving a demand curve from a price-consumption curve

Further falls in the price of X a b

Expenditure on all other goods

B1

B2

I1

I2

Units of good X

Deriving a demand curve from a price-consumption curve

Further falls in the price of X a b c d

Expenditure on all other goods

B1

B2

B3

I I2 3 I1 B4

I4

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I I2 3 I1 B4

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I I2 3 I1 B4

Units of good X Price of good X P1 a

Q1

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I I2 3 I1 B4

Units of good X Price of good X P1 a

P2 P3 P4

b
c d Demand

Q1 Q2 Q3 Q4

Units of good X

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

deriving

the individual's demand curve

Income and substitution effects of a price change

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

deriving

the individual's demand curve

Income and substitution effects of a price change

a

normal good

Income and substitution effects: normal good

Units of good Y

I1 I2 I3 I4 I5 I6

B1 QX1

Units of Good X

Income and substitution effects: normal good

Units of good Y

Rise in the price of good X

h f

I1 I2 I3 I4 I5 I6

B2 QX3 QX1

B1

Units of Good X

Income and substitution effects: normal good

Units of good Y

Substitution effect of the price rise

g
h f

I1 I2 I3 I4 I5 I6

B2 QX3 QX
effect

B1a

B1

QX1

2 Substitution

Units of Good X

Income and substitution effects: normal good

Units of good Y

Income effect of the price rise

g
h f

I1 I2 I3 I4 I5 I6

B2 QX3 QX2 QX1

Income effect Substitution effect

B1a

B1

Units of Good X

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

deriving

the individual's demand curve

Income and substitution effects of a price change

a

normal good inferior good

an

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

I1
I2
QX1 Units of Good X

B1

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

Rise in the price of good X

f h

I1
I2

B2 QX3 QX1

B1 Units of Good X

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

Substitution effect of the price rise

f h

I1
I2

B2 QX2 QX1

B1a

B1 Units of Good X

Substitution effect

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

Income effect of the price rise

f h

I1
I2

B2 QX2 QX3
Income effect

B1a

B1 Units of Good X

QX1
Substitution effect

INDIFFERENCE ANALYSIS

The effect of changes in price

the

priceconsumption curve

deriving

the individual's demand curve

Income and substitution effects of a price change

a

normal good inferior good

an a

Giffen good (a special type of inferior good)

Income and substitution effects: Giffen good

Units of good Y

I1

I2
QX1

B1 Units of Good X

Income and substitution effects: Giffen good

Units of good Y

Rise in the price of good X

I1
h

B2 QX1QX3

I2

B1 Units of Good X

Income and substitution effects: Giffen good

Units of good Y

g f

Substitution effect of the price rise

I1
h

B2 QX2 QX1QX3
Substitution effect

B1a

I2

B1 Units of Good X

Income and substitution effects: Giffen good

Units of good Y

g f

Income effect of the price rise

I1
h

B2 QX2 QX1QX3
Income effect Substitution effect

B1a

I2

B1 Units of Good X

INDIFFERENCE ANALYSIS

The effect of a change in price on the demand for other goods The usefulness of indifference analysis
superiority
limitations

of using ordinal measures

of indifference analysis