Lesson-11. Consumer Market-- Demand and Consumer Behavior

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Wesley Collins
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1 Lesson-11 Consumer Market-- Demand and Consumer Behavior This lesson looks closer at the economic interpretation of consumer demand and explores two approaches to modeling the consumer's choices. The older approach, in terms of "utility," is taken first, and the more recent approach, in terms of "preferences," follows. The preference approach is the one used in more advanced economic theory and should be mastered by students who will pursue further study in economics. A central idea of economics is that people make decisions by weighing costs and benefits. This idea can be stretched to explain the amounts of goods which people buy or sell. The key is to see a decision about the amount to buy or sell as a series of small decisions. To decide how much to buy, for example, a person should consider the costs and benefits of buying the first item and then the costs and benefits of buying the second, etc. Much of economic theory is based on this simple but vital idea. This group of readings begins by looking at goals as the source of benefits and constraints of scarcity as the source of costs. It then shows how one can arrange information obtained from goals and constraints so that one can make decisions based on costs and benefits. It does this by introducing you to two rules, the maximization principle and the equimarginal principle. These rules can be derived mathematically and are in fact nothing but applied calculus. They also make common sense, and these readings stress the common-sense approach to these rules. On completion of this lesson, you should be able to understand the following: To define utility, tradeoff, cost, and law of diminishing marginal utility To understand if given income and prices are able to form a budget constraint To explain what a production-possibilities frontier shows, and what factors can move it To calculate marginal costs and benefits, and vice versa, if given a table of total costs or benefits To use the maximization principle to find optimum positions when given a table or graph showing costs and benefits for various levels of activity To use the equimarginal principle to find optimum positions when given an income and a table showing marginal utilities and prices of two items To know how to explain why the marginal cost curve measures the slope of the total cost curve To understand how to interpret information on a graph showing a budget constraint and indifference curves

2 Understand how to define consumers' surplus and explain how it is measured on a demand curve To understand how to define producers' surplus and explain how it is measured on a supply curve To know how to explain the paradox of value Slide 1 Lesson-3 Consumer Behaviour Objectives: After studying the chapter, you should understand: 1. The purpose of the economic theory of consumer behaviour 2. The difference between that theory and Consumer Behaviour in Marketing 3. The main approaches to consumer behaviour in Economics 1 Slide 2 Economic Theories of Consumer Behaviour ARE NOT rich and highly descriptive analyses of the links between consumers personal, social and psychological characteristics and their purchasing behaviour look for that in the Marketing treatment of the issue They ARE abstract and logical analyses of what is meant by rational choice behaviour and the implications of rational behaviour for instance, is it necessarily true that a rational consumer will buy more of a product as its price falls? begin by defining rational choice and then follow through the consequences 2

3 Slide 3 The Main Approaches Are: Utility Theory Indifference Analysis Revealed Preference The Characteristics Approach 3 Slide 4 Utility Theory Consumers seek to maximise their UTILITY, which increases as they consumer more goods and decreases as they consumer more bads As a consumer has more of a good, the extra (marginal) utility they enjoy from each successive extra unit of the good declines the principle of diminishing marginal utiity A utility-maximising consumer will purchase a combination of goods such that the extra utility acquired per $ or cent, or penny, is the same for every good OR: the ratio of the marginal utilities is equal to the ratio of the prices 4 Slide 5 Utility Theory and Falling Prices If a consumer has a fixed income and begins in equilibrium: MU apples /P apples = MU pears /P pears Then the price of apples falls Left-hand side of the equation> Right-hand side There is an opportunity to increase UTILITY- how to do it? Shift spending from pears to apples - WHY DOES THIS WORK? Because each extra penny spent on apples gives more additional utility than each extra penny spent on pears 5

4 Slide 6 Indifference Analysis UTILITY theory requires us to think in terms of a cardinally measurable unobservable concept, which is rather heroic INDIFFERENCE ANALYSIS explains consumer behaviour on the basis of less restrictive assumptions (tho the logic is very similar) 6 Slide 7 Indifference Analysis The following assumptions are made about rational consumers they know when they prefer one bundle of goods to another or are indifferent between them - their preferences are complete Preferences are symmetric. If I prefer A to B, I cannot prefer B to A. Preferences are transitive. If I prefer A to B and B to C I must prefer A to C. (These are not as unproblematic as they may seem) 7 Slide 8 Indifference Analysis All combinations of A and B for which the consumer is indifferent AN INDIFFERENCE CURVE 8

5 Slide 9 Indifference Analysis An A-lover Slopes show relative preferences for A and B 9 Slide 10 An Indifference Map The preferred direction if A and B are both goods 10 Slide 11 The Optimal Combination of A and B Budget Line 11

6 Slide 12 Budget Line If the Price of B Falls More B is bought and (in this example only) the same amount of A 12 Slide 13 What Can We Say In General About the Consequences of a Price Fall? The overall move from one equilibrium to another is the PRICE EFFECT PRICE EFFECT can be divided into SUBSTITUTION EFFECT and INCOME EFFECT SUBSTITUTION EFFECT is the result of changing prices INCOME EFFECT is the result of changing real incomes 13 Slide 14 How to Find the Substitution and Income Effects? Budget Line More B is bought (and in this example only) the same amount of A 14

7 Slide 15 Substitution Effect If the consumer was on the same I-curve as before (same real income) but prices moved to their new level, (budget line has the new slope) more B must be bought 15 Slide 16 Income Effect If relative prices don t change but real income rises 16 Slide 17 Income Effect The substitution effect MUST lead more B to be bought if the relative price of B falls The Income effect could work in either direction or be neutral for inferior goods, income effect is negative for normal goods it is positive A GIFFEN good is one where the income effect is negative and powerful enough to outweigh the substitution effect lower prices, less is bought 17

8 Slide 18 Other Approaches Indifference analysis, and its mathematical version, is the standard approach Revealed Preference and the Characteristics Approach merit brief consideration 18 Slide 19 Revealed Preference Less restrictive assumptions - consumers are consistent in their choices A budget line is constructed and the consumer s choice observed When price of one good falls, a new choice is made The new choice cannot involve less of the good whose price has fallen 19 Slide 20 Revealed Preference Why? If combination X is the original choice and Apples Z is the new choice (after the price of oranges falls), X to Z is the price effect. The broken line shows the goods which could be bought if income remained at the level requiredto buy the original basket of goods, but the new price ratio held. We don t know exactly where the consumer would choose to be, but they cannot be to Z the left of X because they have already rejected superior combinations in favour of X X Oranges 20

9 Slide 21 The Characteristics Approach Lancaster 1966 Consumers do not desire goods but bundles of characteristics not a computer but processing speed memory storage functions Different brands offer different combinations of characteristics. Combining brands may allow other combinations to be achieved Desirable mixes of characteristics might be identified 21 Slide 22 Practical Applications of Demand Theory? LIMITED. The purpose is to examine the meaning and consequences of rational behaviour Forms the theoretical foundation for statistical analyses of demand The characteristics concept is a useful starting point in Marketing and has led to ideas like hedonic price models. Take many different examples or brands of a good. Regress the price on the characteristics to see how the market prices them In Hong Kong, residential property prices are determined by net floor area, but age, a view of water, pollution and family density also had significant (but small) effects 22

MICRO-ECONOMIC THEORY I STUDY NOTES CHAPTER ONE

MICRO-ECONOMIC THEORY I STUDY NOTES CHAPTER ONE UNIT 1 BASIC CONCEPT OF CONSUMER BEHAVIOUR CHAPTER ONE CONTENTS Introduction Objectives Main Content Theory of Consumer Behaviour Consumer Preferences Decisiveness