Managerial Economics

Demand Analysis

MODULE III
Demand Analysis: Consumer Behavior (Utility)
❖ Utility Theory
• The ability of goods and services to satisfy consumer wants is the basis for consumer demand.
Let utility describe the level of satisfaction or benefit that consumers receive from consuming
various goods.

❖ Basic Assumptions of Utility Theory

• Consumer behavior theory rests upon three basic assumptions regarding the utility tied to
consumption.
1. First, more is better. Consumers always prefer more to less of any good or service.
Economists refer to this as the nonsatiation principle. The nonsatiation principle is best
considered within the context of money income where more money brings additional
satisfaction or well-being.
2. Second, preferences are complete. When preferences are complete, consumers are able to
compare and rank the benefits tied to consumption. If preferences are complete, consumers
know they prefer spicy chicken wraps to shredded beef wraps, or vice versa. If both provide
the same amount of satisfaction or utility, the consumer is said to display indifference
between the two. Indifference implies equivalence in the eyes of the consumer. A consumer
can be indifferent between goods and services that are distinct in a physical sense. What's
important in the case of consumer indifference is that two products yield the same amount
ofsatisfaction or well-being to the consumer.
3. Third, preferences are transitive. When preferences are transitive, consumers are able to
rank order the desirability of various goods and services. If a consumer prefers spicy chicken
wraps to shredded beef wraps, and prefers shredded beef wraps to vegetarian wraps, then that
consumer also prefers spicy chicken wraps to vegetarian wraps. Consumer understanding of
ordinal utility makes possible a rank ordering of preferred goods and services. If consumers
had understanding of cardinal utility, they would know how much spicy chicken wraps are
preferred, say 2:1 or 3:1, over vegetarian wraps. However, nobody has to know how much
more desirable spicy chicken wraps are compared to vegetarian wraps in order to make a
simple choice between the two. All that's necessary is to know that one product is preferred to
another product.

❖ Utility Functions
• A utility function is a descriptive statement that relates satisfaction or well-being to the
consumption of goods and services and can be written in the general form:
Utility =f(Goods, Services)
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Demand Analysis

• Bundles of items desired by consumers are called market baskets because they reflect
combinations of goods and services available in the marketplace.
• The utility derived from consumption is intangible. However, consumers reveal their preferences
through purchase decisions and thereby provide tangible evidence of utility. The height of the bar
associated with each combination of goods and services indicates the level of utility provided
through the consumption of those items.

❖ Marginal Utility
• Whereas total utility measures the consumer's overall level of satisfaction derived from
consumption activities, marginal utility measures the added satisfaction derived from a 1-unit
increase in consumption of a particular good or service, holding consumption of other goods and
services constant.
• The nonsatiation assumption requires that marginal utility is positive, MU(X) > 0. Marginal
utility tends to diminish as consumption increases within a given time interval.
• If each cheeseburger costs $3, the cost per unit (util) of satisfaction derived from consuming the
first cheeseburger is 60^ (=$3/5 utils). A second cheeseburger costing $2.40 produces 4 utils of
additional satisfaction at a cost of 60c per util. Diminishing marginal utility increases the cost of
each marginal unit of satisfaction. If the typical Hamburger Stand customer had alternative
consumption opportunities providing one additional unit of utility for 60^ each, customers would
be willing to increase the quantity of cheeseburgers purchased only if cheeseburger prices fell. A
cheeseburger price of $2.40 (=60(jx4 utils) would be necessary to induce the typical customer to
buy a second cheeseburger, $1.80 would be needed for a third, $1.20 for a fourth, and so on. This
gives rise to the downward-sloping demand curve

❖ Law of Diminishing Marginal Utility

• The law of diminishing marginal utility states that as an individual increases consumption of a
given product within a set period of time, the marginal utility gained from consumption
eventually declines. This law gives rise to a downward-sloping demand curve for all goods and
services.
• When service is held constant at 4 units, the marginal utility derived from consuming goods falls
with each successive unit of consumption. Similarly, the consumption of services is subject to
diminishing marginal utility. Holding goods consumption constant at 1 unit, the marginal utility
derived from consuming services falls continuously. The added benefit derived through
consumption of each product grows progressively smaller as consumption increases, holding the
other constant.
• To a greater or lesser degree, goods and services can be substituted for one another. For example,
a consumer may own many suits and dry-clean each suit only occasionally. A consumer may own
only a few suits but dry-clean each one frequently. In the first instance, the consumer has bought
a market basket with a high proportion of total expenditures devoted to suits (goods) and
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Demand Analysis

relatively little devoted to dry-cleaning services. The latter market basket is weighted less toward
goods and more toward services.

❖ Indifference Curve
• Indifference curves represent all market baskets that provide a given consumer the same amount
of utility or satisfaction.
• Indifference curves have four essential properties.
1. First, higher indifference curves are better. Consumers prefer more to less, so they prefer
higher indifference curves that represent greater combinations of goods and services to lower
indifference curves that represent smaller combinations of goods and services. As illustrated
in Figure 4.3, indifference curves that are found upward and to the right are preferred to
lower indifference curves found downward and to the left.
2. Second, indifference curves do not intersect. Holding goods constant, an indifference curve
involving a greater amount of services must give greater satisfaction. Holding services
constant, an indifference curve involving a greater amount of goods must give greater
satisfaction. This stems from the fact that goods and services both provide consumer benefits,
and reflect the 'more is better' principle. If indifference curves crossed, this principle would
be violated.
3. Third, indifference curves slope downward. The slope of an indifference curve shows the
trade-off involved between goods and services. Because consumers like both goods and
services, if the quantity of one is reduced, the quantity of the other must increase to maintain
the same degree of utility. As a result, indifference curves have negative slopes.
4. And fourth, indifference curves bend inward (are convex to the origin). The slope of an
indifference curve shows the rate at which consumers are willing to trade off goods and
services. When goods are relatively scarce, the law of diminishing marginal utility means that
the added value of another unit of goods will be large in relation to the acided value of
another unit of services. Conversely, when goods are relatively abundant, the added value of
another unit of goods will be small in relation to the added value of another unit of services.
This gives indifference curves a bowed inward, or concave to the origin, appearance.

❖ Perfect Substitutes and Perfect Complements

• Substitutes are goods and services that can be used to fulfill a similar need or desire. Goods and
services that become more desirable when consumed together are called complements. Going to
the movies and renting a DVD are close substitutes. At the same time, many consumers like to
consume buttered popcorn and soda at the movie theater. Movies, buttered popcorn, and soda are
often complements.
• Insight concerning the indifference curve concept can be gained by considering what indifference
curves look like for the logical extremes of perfect substitutes and perfect complements. Perfect
substitutes are goods and services that satisfy the same need or desire. Perfect complements are
goods and services consumed together in the same combination.
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• Because almost all goods and services have at least some small degree of uniqueness or
individual appeal, it's difficult to find good examples of perfect substitutes. Take Pepsi and Coca-
Cola, for example. Many consumers drink both. That's why competition is so fierce for shelf
space at the grocery store. A summertime pricing promotion featuring 12-packs of Diet Coke can
cause sales of Diet Coke to skyrocket, and make sales of Diet Pepsi plummet. Still, many devoted
Pepsi drinkers will turn down even promotionally priced Coke in favor of Pepsi. Coke and Pepsi
are close substitutes, but they are not perfect substitutes. Good example of near-perfect substitutes
are provided by Visa debit cards and Visa credit cards, generic and branded drugs, drive-through
and dine-in service at your favorite fast-food restaurant, and DVD movie rentals versus purchases
• There are lots of simple examples of perfect complements. Casual shoes and sandals are good
substitutes, but a right shoe and a left shoe are perfect complements. They are always worn
together in a 1:1 ratio. Similarly, most homes have a single clothes washer and clothes dryer (1:1
ratio), cars have four tires (4:1 ratio), and so on. As shown in Figure 4.4(b), bicycle tires and
bicycle frames are 'consumed' in a 2:1 ratio. No matter how many frames you have, you can't
have more than one bicycle if you have only two tires. You cannot have more than two bicycles if
you have no more than two bicycle frames.
• When goods and service can be freely but imperfectly substituted, indifference curves have the
U-shape.
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❖ Budget Constraints
• A budget constraint represents all combinations of products that can be purchased for a fixed
amount. To derive a budget constraint, add up the amount of spending on goods and services that
is feasible with a given budget. The amount of spending on goods is equal to the product of Py,
the price of goods, times V, the quantity purchased total spending on services is Px x X. When
these amounts are added together, the budget constraint is
o Total Budget = Spending on Goods + Spending on Services
o B = PyY + PxX
• The effect of a budget increase is to shift a budget constraint outward and to the right. The effect
of a budget decrease is to shift a budget constraint inward and to the left. So long as the relative
prices of goods and services remain constant, budget constraints remain parallel
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Demand Analysis

• (a) An increase in budget results in a parallel outward shift in the budget constraint, (b) A price
cut allows purchase of a greater quantity with a given budget.
• A fall in the price of goods or services permits an increase in consumption and consumer welfare.
If both prices fall by a given percentage, a parallel rightward shift in the budget constraint occurs
that is identical to the effect of an increase in budget.

❖ Income and Substitution Effect

• The income effect of a price change is the increase in overall consumption made possible by a
price cut, or decrease in overall consumption that follows a price increase. The income effect
shifts buyers to a higher indifference curve following a price cut or shifts them to a lower
indifference curve following a price increase.
• The substitution effect of a price change describes the change in relative consumption that occurs
as consumers substitute cheaper products for more expensive products. The substitution effect
results in an upward or downward movement along a given indifference curve. The total effect of
a price change on consumption is the sum of income and substitution effects.

❖ Price – Consumption Curve

• If income and the prices of other goods and services are held constant, a reduction in the price of
a given item causes consumers to choose different market baskets. Various market baskets that
maximize utility at different prices for a given item trace out the consumer's price-consumption
curve. (See book for illustration of the curve and examples)

❖ Income – Consumption Curve

• The income-consumption curve portrays the utility-maximizing combinations of goods and
services at every income level. As shown in Figure 4.8, the income-consumption curve slopes
upward because the consumption of both goods and services can rise with growing income.
Whereas an individual demand curve shows the relation between price and quantity demanded, or
movement along the demand curve, the income-consumption curve shows shifts in demand from
one demand curve to another as income changes.
• It is worth emphasizing that price-consumption curves and income-consumption curves focus on
different aspects of demand. Price-consumption curves show how optimal consumption is
affected by changing prices, or movements along the demand curve. Income-consumption curves
illustrate the effects of shifts in demand due to changing income.

❖ Engle Curve
• A plot of the relationship between income and the quantity consumed of a good or service is
called an Engle curve, named after economist Ernst Engle. Engle curves are closely related to
income-consumption curves.
• If consumers have a tendency to buy more of a product as their income rises, such products are
called normal goods. This is true for most goods and services. If consumers tend to buy less of a
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Demand Analysis

product following an increase in income, such products are called inferior goods. The term
inferior good does not necessarily reflect substandard quality. It simply refers to the fact that
consumption and income tend to be inversely related for certain products, such as bus rides and
hamburgers.
• Engle curves plot the effects of changing income on consumption using a graph with income on
the vertical Y-axis and consumption on the horizontal X-axis. Because most products are normal
goods that display a positive relationship between income and consumption, income-consumption
curves and Engle curves tend to have a positive slope. In the case of inferior goods, income-
consumption curves and Engle curves have a negative slope.

• Engle curves slope upward for all normal goods and services, but are backward-bending in the
case of inferior goods and services. The consumption of some goods and services, like bus rides
and hamburgers, can actually begin to fall as income rises. The wealthy tend to choose
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Demand Analysis

automobile transportation rather than bus rides, and prefer steak to hamburger. The number of bus
rides taken per month rises up to an income level of $500 per month, after which point the
number of bus rides taken begins to fall as income rises. When income exceeds $500 per month,
an inverse relation exists between bus rides and income. Over this range, bus rides are an inferior
good.

❖ Marginal Utility and Consumer Choice

• The best allocation of a budget is the allocation that maximizes the utility, or satisfaction, derived
from consumption. The resulting optimal market basket of goods and services must satisfy two
important conditions.
1. First, the optimal market basket lies on the budget line. Remember, the budget line
represents all combinations of goods and services that can be purchased for a fixed amount.
Market basket combinations that lie above and to the right of the budget lines drawn in
Figures 4.5 and 4.6, for example, are too expensive to purchase with the given limited funds.
Purchase of market baskets that lie below and to the left of these budget lines would leave
funds unspent, and reduce consumption of valuable goods and services. The best feasible
market basket combination lies on the budget line.
2. And second, the optimal market basket reflects consideration of marginal benefits and
marginal costs. Marginal analysis involves a comparison between added costs and added
benefits. In terms of consumption decisions, consumers must weigh the relative marginal
benefits and relative marginal costs derived from consumption. At the margin, if consumers
derive twice as much satisfaction from the consumption of goods as from the consumption of
services, then consumers would be willing to pay twice the marginal cost (price) for goods as
opposed to services.
• For example, suppose you had just finished a vigorous late-afternoon workout at a local health
club. Only after quenching a burning thirst would it seem reasonable to order dinner or some
snacks. Such behavior is a common reflection of the type of marginal analysis that everyone
conducts when making consumption decisions. If a given consumer consistently chooses a given
market basket over another less expensive market basket, then the consumer has a revealed
preference for the chosen market basket. A revealed preference is a documented desire for a given
good or service over some other less expensive good or service.

❖ Marginal Rate of Substitution

• The slope of each indifference curve equals the change in goods (∆Y) divided by the change in
services (∆X). This relation, called the marginal rate of substitution, is simply the change in
consumption of Y (goods) necessary to offset a given change in the consumption of X (services)
if the consumer's overall level of utility is to remain constant. This can be stated as:
MRS = ∆Y/∆X = Slope of an Indifference Curve
• The marginal rate of substitution (MRS) diminishes as the amount of substitution increases. For
example, in Figure 4.10, as more goods are substituted for services, the amount of services
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necessary to compensate for a given loss of goods will continue to fall. As more services are
substituted for goods, the amount of goods necessary to compensate for a given loss of services
will continue to fall. This pattern means that the negative slope of each indifference curve tends
to approach zero as one moves from left to right.
• Thus, the slope of an indifference is determined by the ratio of marginal utilities derived from
each product. As one moves from left to right, the slope of each indifference curve goes from a
large negative number toward zero. This implies that MUx decreases relative to MUy as the
relative consumption of X progressively increases.
• Utility is maximized when the marginal utility derived from each individual product is
proportional to the price paid. It shows that optimal market baskets of goods and services are
indicated by points of tangency between respective indifference curves and budget constraints.
• Utility is maximized when products are purchased at relative prices that equal the relative
marginal utility derived from consumption.