CONSUMER DEMAND (CHOICE)

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GMT - 11 Hours CONSUMER DEMAND (CHOICE)

Post by modi on Sun Oct 27, 2013 12:26 pm

 
MICROECONOMIC THEORY – PRODUCT MARKETS
 
 
 
CONSUMER DEMAND (CHOICE)
 
 
 
Consumer demand is the largest component of the total demand for products. Economists
 
believe, as previously discussed, that consumer demand behaves according to the LAW OF
 
DEMAND, i.e. the higher the price of a product, the lower the quantity demanded of the product,
 
other things equal (ceteris paribus) and vice versa. This means that consumer demand is a
 
negative relationship between price and quantity and will graph as a curve that slopes downward
 
to the right. But why do consumers demand more the lower the price and less the higher the
 
price?  What are the underlying reasons that support the law of demand?  Why does the
 
consumer demand curve slope downward and to the right?  According to economist the answers
 
to these questions are because of the income effect, the substitution effect and diminishing
 
marginal utility.   
 
 
Income Effect, Substitution Effect and Diminishing Marginal Utility
 
   These three factors are the primary reasons why consumers demand products the way they
 
   do and are important to understand. 
 
   Income Effect
 
-       As the price of a product changes, consumers effectively have more or less to
 
                       spend on a product. Note that although their actual income has not changed as we
 
                       assume it is constant, their “real income” has changed meaning they can by more
 
                       or less with the same income as before.
 
-       As the price of a product falls, real income rises and consumers will buy more.
 
When the price increases, real income falls and consumers will buy less.
 
  Substitution Effect
 
-       As the price of a product changes, consumers will evaluate purchasing more or
 
                       less of a substitute produce.
 
-       When the price of a product falls, consumers will buy more of it and less of a
 
                       substitute product. When the price of a product increases, consumers will buy less
 
                       of it and more of a substitute product which is now relatively less expensive.
 
  Diminishing Marginal Utility
 
-       Diminishing marginal utility is an important concept in economics. The law of
 
                       diminishing marginal utility states that as additional units of a product are
 
                       consumed, the utility derived from each additional unit declines, ceteris paribus.
 
Economist measure utility or satisfaction in “utils”.  Utils are an abstract measure
 
and can not actually be calculated.  Diminishing marginal utility works like this.
 
If you have just been rescued after spending 4 days lost in the desert, the first
 
glass of water you drink is very high in utils, the second glass is also very high in
 
utils, but not as high as the first glass, the third glass is high in utils, but not as high
 
as the second glass. So as additional glasses of water are consumed, the level of
 
satisfaction derived from each successive glass of water is less than that derived
 
from the previous glasses.
 
-       Since marginal utility declines as more units of a product are consumed,
 
                        consumers will not pay the same price for additional units because they are
                      
                         worth less in terms of utils. 
 
Because of the above three factors, the consumer demand curve is always downward sloping   
 
to the right.
 
Total Utility vs. Marginal Utility
 
    TOTAL UTILITY (TU) is the total satisfaction derived from the total number of units of a
 
    Product consumed. Total utility = the sum of the satisfaction derived from each unit.
 
    MARGINAL UTILITY (MU) is the satisfaction derived from each unit of a product consumed.
 
    Marginal utility = the change in TU divided by the change in the number of units (Q)
 
    consumed.  As discussed above, economists believe marginal utility continuously declines;
 
    as more of a product is consumed, the satisfaction from each “additional” unit declines.
 
    Therefore total utility will continue to rise (as each unit of a product is consumed) as long as
 
    the marginal utility (which is declining) stays positive. When marginal utility becomes
 
    negative (no more of a good is wanted even if it is free), total utility will then start to decline.
 
 
    For example:                                                MARGINAL                TOTAL
                                     CONSUMPTION           UTILITY                  UTILITY             
                                   1ST glass of water            100 utils                  100 utils
                                    2nd glass                           90                         190
                                    3rd glass                            80                         270
                                    4th                                      50                         320
                                    5th                                      20                         340
                                    6th                                     -10                         320
 
Notice in the above example that while marginal utility always declines as consumption increases, 
 
total utility increases as consumption increases until marginal utility = 0.  When
 
marginal utility is negative, total utility is declining.
 
    Important note:  If marginal utility of a product declines as more units of it are consumed,
 
     then marginal utility will rise if less units of it are consumed!     
 
Maximizing Utility
 
    How do consumers go about maximizing their total utility when purchasing two or more
  
    different products? The simple answer is that they spend their money so that they receive the
  
    highest marginal utility (MU) per $1.00 spent.  As a simple example, assume that you could
 
    buy good A and that it would provide you with a marginal utility of 10 units of satisfaction “per
  
    dollar”. Or you could buy good B and get a marginal utility of 15 units of satisfaction “per
  
    dollar”.  Which one would you select?  A rational consumer would choose Good B of course! 
  
  
 
 Since consumers strive to maximize satisfaction, they will purchase in theory a combination of
  
    products where the “per dollar” marginal utilities are equal. At this point where the per dollar
  
    marginal utilities are equal, a consumer can not increase total utility by purchasing more of
  
     one and less of another, i.e. they have  maximized their total utility.
 
        
         Calculation of Marginal Utility Per Dollar
 
              Per dollar marginal utility is found by dividing the marginal utility (MU) gained from the
            
              purchase of a unit of a product by the price of the product. For example, if the MU from
             
              purchasing a unit of a product is 240 utils and the product costs $4.00/unit, the MU per
            
              $1.00 spent = 60 utils.
 
   To maximize utility then, the MU per dollar of each unit of a product purchased must be equal.                          
 
   This can otherwise be stated as follow: the MU of product A divided by PRICE of product A =
 
   MU of product B divided by the PRICE of product B. This formula is also called the Utility
    
    Maximizing Rule.
 
   Let’s look at an example how a consumer goes about maximizing utility according to the utility
  
   maximizing rule.
         
                         Assume: consumer has $160 to spend on three products a, b & c. The prices
                                         and marginal utility (MU) of each are shown below. Note that when a
                                         unit of a product is purchased the MU of its next unit is lower.
 
                                  PRODUCTS
                     a                    b                       c                Product Chosen      Income Spent
  Price:       $10                $50                  $100 
  Utils:          40 MU          150 MU             250 MU        1st A at 4 MU/$1           $10
                    20 MU                                                        2nd B at 3 MU/$1            60
                                         100 MU                                 3rd C at 2.5 MU/$1        160
                                                                  200 MU
 
The above consumer has maximized total utility with the three purchases shown.  Why?
Note in the above table that as a unit of product a, b or c is purchased, the utils of the next unit   (marginal util) go down, e.g. 40 to 20 for a, 150 to 100 for b and 250 to 200 for c (law of diminishing marginal utility).
 
   Applications of Utility Maximization Rule
 
       1). Selection of product to purchase next.
                 If:  MUa  >  MUb      
                        Pa          Pb       consumer should buy more of product a. Why?
 
                 If:   MUa  <  MUb
                          Pa         Pb      consumer should buy more of product b.  Why?
 
        2).  Diamond/Water Paradox
 
                  The price of diamonds a non-essential product is high. The price of water an
                   essential product is low. Why?
 
                                        MU OF WATER ?  MU OF DIAMONDS ?
                                         P WATER LOW         P DIAMONDS HIGH
 
                  The reason for the paradox is that the MU of water is low and the price of diamonds
                   
                  is high. Note that the “total utility” of water is very high, but the total utility of
                   
                  diamonds is low.
  
          3).  Non-Cash Vs. Cash Gifts
                 
                    Which type of gift would you prefer?
                   
                     Most people would choose a cash gift because non-cash gifts often don’t match
                     a persons taste or preferences and the MU of a cash gift is higher because the
                     person can choose to buy the product that gives the greatest MU/$1.
 
           4).  Value of Time
             
                  We have not factored in the “cost” of time in our analysis of consumer demand.
                  Time does have value and can make a difference in demand. The cost (price) of a
                   product that requires a lot of time to use is higher when the value of time is added.                         
 
 
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