Economics 10 Slide Set 3: Consumer Choice Market Demand & Elasticity University of North Carolina Chapel Hill Lecture Outline Consumer preferences, Utility diminishing marginal utility Marginal Benefit, money values and utility Optimal urchase Rule Individual Demand Curve Consumer's Surplus Market Demand Elasticity calculation relationship to total revenue rices, Income and the Quantity Demanded Overview of Microeconomic Theory Observations Assumptions Decisions Model-> "tool" Aggregation of decisions Consumer Behavior Utility Max Market Individ. Demand Budget constraint Demand Cost min. rofit max. Firm Behavior supply decisions Market Equilibrium Market Supply Market Structure Interaction of Supply and Demand Econ 10 (3) Individ Demand_p.RZ 1-3 Econ 10 UNC-CH 01/19/05
Definitions you need to know Total and Marginal Utility Total utility Marginal utility The Law of Diminishing Marginal Utility Table and graph of total and marginal utility functions Consumer Choice: The Demand Side of the Market Quantity Total Utility Marginal Utility (benefits) oint 0 0.00 1 6.00 6.00 A 2 11.60 5.60 B 3 16.00 4.40 C 4 19.60 3.60 D 5 21.40 1.80 E 6 22.20 0.80 F 7 22.60 0.40 G 8 22.60 0.00 H The rule presented here is for a would where quantity is continuous. How would it change in a world where quantity is not a continuous variable? The Optimal urchase Rule A consumer should buy the quantity of each good at which price and marginal utility (benefits)are exactly equal. Econ 10 (3) Individ Demand_p.RZ 4-6 Econ 10 UNC-CH 01/19/05
From Marginal Utility to the Demand Curve Because people's marginal utility declines with the number of goods bought, demand curves are negatively sloped. List of Optimal Quantities to urchase at Alternative rices rice Quantity urchased.40 7.86 6 1.80 5 3.60 4 4.40 3 5.60 2 6.00 1 Consumer's Surplus: The Net Gain From a urchase Since purchases are voluntary, it follows that the purchaser must come out ahead. The net benefit to the purchaser is called consumer's surplus, and is measured by the sum, over each unit bought, of the excess of marginal utility (benefits) above price. Calculating Marginal Net Utility Consumer Surplus Quantity Marginal Utility rice Marginal Net Utility 1 $6.00 $3.60 $2.40 2 5.60 3.60 2.00 3 4.40 3.60 0.80 4 3.60 3.60 0.00 Total $5.20 Econ 10 (3) Individ Demand_p.RZ 7-9 Econ 10 UNC-CH 01/19/05
Consumer Surplus Marginal Utility and rice per Serving $7 6 5 4 3 2 1 $6.00 $2.40 $3.60 Total consumer surplus of 4 units, $2.40 + $2.00 + $.80 + $0 =$5.20 $5.60 $2.00 $4.40 $.80 $3.60 $3.60 $3.60 $3.60 1 2 3 4 Number of Maknoogat Servings urchased Marginal Utility (Demand) Curve rice = $3.60 Example Using Consumer Surplus to understand a ricing ractice Each individual has a demand curve for local telephone call. How much do you actually pay per call? How can Southern Bell do that? How much would you pay to have unlimited free local calling? If the monthly fee is less than your consumer surplus for free calls, you buy phone service. per call $2 30 Calls per week From Individual Demand Curves to Market Demand Curves A market demand curve shows how the total quantity demanded of some product during a specified period of time changes as the price of that product changes, holding other things constant. The market demand curve is the horizontal sum of the individual demand curves. Econ 10 (3) Individ Demand_p.RZ 10-12 Econ 10 UNC-CH 01/19/05
Individual Demand Curves to Market Demand Curve Consumer 1 Consumer 2 Market $3 $1 4 8 2 10 6 18 Q1 Q2 Q MKT Elasticity of Demand (or anything else) The sensitivity to price (or something else) measured in percentage change Definition: price elasticity of demand = ercent change in quantity demanded ercent change in price = h rice Elasticity of Demand Math version of definition η = Q/Q / Q = Q Notes: The 's and Q's come from points on a demand curve. The "negative sign" is a convention to make the elasticity a positive number. Demand is "elastic" if h > 1 Demand is "inelastic" if h <1 Demand is "unitary elastic" if h =1 Econ 10 (3) Individ Demand_p.RZ 13-15 Econ 10 UNC-CH 01/19/05
Elasticity of Demand Calculating elasticity, "arc elasticity" h = Change in Q/(ave. Q) -2/((8+10)/2) = Change in /(ave. ) -.1/((1+1.1)/2) = 2.333 $1.10 $1.00 +.1 Demand Curve -2 8 10 Q Elasticity is NOT the Slope of the Demand Curve η = Q/Q / Q = Q oint Elasticity 1/(slope of demand curve) D DQ 1 Demand Q Elasticity and the "Shapes" of Demand Curves Always remember: The elasticity and the slope of the demand curve are not the same thing 0< h < 4 η = Q Q Constant on a straight line Econ 10 (3) Individ Demand_p.RZ 16-18 Econ 10 UNC-CH 01/19/05
Elasticity and Total Revenue Total Revenue = TR = xq where and Q are points on the demand curve Elastic Demand: up --> TR down Inelastic Demand: up --> TR up Unitary elastic: up --> TR constant Elasticity and Total Revenue Total Revenue = rice x Quantity Marginal Revenue: is the change in total revenue per change in quantity = dtr(q)/dq = d((q) xq)/dq = + (d/dq)q = (1 + (d/dq)q/) = (1- (1/elasticity)) For linear demand =a - bq TR = *Q = aq - bq 2 MR= dtr/dq = a - 2bQ 1.00.98.80 NET Gain = $.98 -$.18 = $.80 = MR between 9 & 10 units Loose $.02 on 9 units = loss $.18 Marginal Revenue Function 9 10 Gain $.98 on one more sold Demand Curve Q What would be the sign of a the cross price elasticity of a substitute good? of a complement good? Cross Elasticity of Demand: Substitutes and Complements The cross elasticity of demand for roduct X with respect to the price of product Y = % change in quantity of X demand % change in price of Y Econ 10 (3) Individ Demand_p.RZ 19-21 Econ 10 UNC-CH 01/19/05
What would be the sign of the income elasticity for a normal good? for an inferior good? Income Elasticity of Demand: Normal and Inferior Goods The income elasticity of demand for roduct X = % change in quantity of X demand % change in income Econ 10 (3) Individ Demand_p.RZ 22-24 Econ 10 UNC-CH 01/19/05