Chapter 5: Demand and Consumer Behavior

Choice and Utility Theory

In the theory of demand, we assume that people maximize their utility, which
means that they choose the bundle of consumption goods that they most prefer.

Marginal Utility and the Law of Diminishing Marginal Utility

When you eat an additional unit of ice cream, you will get some additional
satisfaction or utility. The increment to your utility is called marginal utility. The
expression “marginal” is a key term in economics and always means “additional” or
“extra.” Marginal utility denotes the additional utility you get from the consumption
of an additional unit of a commodity.
The law of diminishing marginal utility states that, as the amount of a good
consumed increases, the marginal utility of that good tends to decline.

Derivation of Demand Curves

The Equimarginal Principle
A satisfactory rule would be: If good A costs twice as much as good B, then buy
good A only when its marginal utility is at least twice as great as good B’s marginal
utility. This leads to the equimarginal principle that I should arrange my
consumption so that the last dollar spent on each good is bringing me the same
marginal utility.
The Equimarginal Principle is the fundamental condition of maximum satisfaction
or utility. It states that a consumer will achieve maximum satisfaction or utility when
the marginal utility of the last dollar spent on a good is the same as the marginal
utility of the last dollar spent on any other good.
The common marginal utility per dollar of all commodities in consumer equilibrium
is called the marginal utility of income. This fundamental condition of consumer
equilibrium can be written in terms of the marginal utilities ( MUs ) and prices ( Ps )
of the different goods in the following compact way:
Why Demand Curves Slope Downward
A higher price for a good reduces the consumer’s desired consumption of that
commodity; this shows why demand curves slope downward.

Leisure and the Optimal Allocation of Time

A Spanish toast to a friend wishes “health, wealth, and the time to enjoy them.”
This saying captures the idea that we must allocate our time budgets in much the
same way as we do our dollar budgets.
Consider leisure, often defined as “time which one can spend as one pleases.”
Leisure brings out our personal eccentricities. The principles of consumer choice
suggest that you will make the best use of your time when you equalize the
marginal utilities of the last minute spent on each activity.
The same rule of maximum utility per hour can be applied to many different areas
of life, including engaging in charitable activities, improving the environment, or
losing weight. It is not merely a law of economics. It is a law of rational choice.

Analytical Developments in Utility Theory

Economists today generally reject the notion of a cardinal (or measurable) utility
that people feel or experience when consuming goods and services. Utility does
not ring up like numbers on a gasoline pump. Rather, what counts for modern
demand theory is the principle of ordinal utility. Under this approach, consumers
need to determine only their preference ranking of bundles of commodities.
Ordinal utility asks, “Do I prefer a pastrami sandwich to a chocolate milk shake?” A
statement such as “Bundle A is preferred to bundle B”— which does not require
that we know how much A is preferred to B — is called ordinal, or dimensionless.
Ordinal variables are ones that we can rank in order, but for which there is no
measure of the quantitative difference between the situations.
For certain special situations, the concept of cardinal, or dimensional, utility is
useful. An example of a cardinal measure comes when we say that the speed of a
plane is six times that of a car. People’s behavior under conditions of uncertainty is
today analyzed using a cardinal concept of utility

An Alternative Approach: Substitution Effect and Income

Effect
The concept of marginal utility has helped explain the fundamental law of
downward-sloping demand. But over the last few decades, economists have
developed an alternative approach to the analysis of demand—one that makes no
mention of marginal utility. This alternative approach uses “indifference curves”
Indifference analysis asks about the substitution effect and the income effect of a
change in price. By looking at these, we can see why the quantity demanded of a
good decline as its price rises.

Substitution Effect
If the price of coffee goes up while other prices do not, then coffee has become
relatively more expensive. The substitution effect says that when the price of a
good rises, consumers will tend to substitute other goods for the more expensive
good in order to satisfy their desires more inexpensively.
Consumers, then, behave the way businesses do when the rise in price of an input
causes fi rms to substitute low-priced inputs for high-priced inputs. By this process
of substitution, businesses can produce a given amount of output at the least total
cost. Similarly, when consumers substitute less expensive goods for more
expensive ones, they are buying a given amount of satisfaction at lower cost.

Income Effect
The term real income means the actual quantity of goods that your money income
can buy. When a price rises and money income is fixed, real income falls because
the consumer cannot afford to buy the same quantity of goods as before.
This produces the income effect, which is the change in the quantity demanded
that arises because a price change lowers consumer real incomes. We can obtain
a quantitative measure of the income effect using a new concept, income
elasticity. This term denotes the percentage change in quantity demanded divided
by the percentage change in income, holding other things, such as prices,
constant:

Income and substitution effects combine to determine the major characteristics of

demand curves of different commodities.

From Individual to Market Demand

The demand curve for a good for the entire market is obtained by summing up the
quantities demanded by all the consumers.
Each consumer has a demand curve along which the quantity demanded can be
plotted against the price; it generally slopes downward and to the right. If all
consumers were exactly alike in their demands and if there were 1 million
consumers, we could think of the market demand curve as a millionfold
enlargement of each consumer’s demand curve.
As a matter of convention, we label individual demand and supply curves with
lowercase letters ( dd and ss), while using uppercase letters ( DD and SS ) for the
market demand and supply curves.

Demand Shifts
An increase in income tends to increase the amount we are willing to buy of most
goods. Necessities tend to be less responsive than most goods to income
changes, while luxuries tend to be more responsive to income.
The demand curve shows how the quantity of a good demanded responds to a
change in its own price. But the demand is also affected by the prices of other
goods, by consumer incomes, and by special influences. The demand curve was
drawn on the assumption that these other things were held constant

Substitutes and Complements

We say, therefore, that beef and chicken are substitute products. Goods A and B
are substitutes if an increase in the price of good A will increase the demand for
substitute good B.
Hamburgers and hamburger buns, or cars and gasoline, on the other hand, are
complementary products; they are called complements because an increase in
the price of good A causes a decrease in the demand for its complementary good
B.
In between are independent goods, such as beef and textbooks, for which a price
change for one has no effect on the demand for the other. Try classifying the pairs
turkey and cranberry sauce, oil and coal, college and textbooks, shoes and
shoelaces, salt and shoelaces.

Empirical Estimates of Price and Income Elasticities

All these applications require a numerical estimate of price elasticity. Similar
decisions depend on income elasticities.
A government planning its road or rail network will estimate the impact of rising
incomes on automobile travel; the federal government must calculate the effect of
higher incomes on energy consumption in designing policies for air pollution or
global warming; in determining the necessary investments for generating capacity,
electrical utilities require income elasticities for estimating electricity consumption.
Economists have developed useful statistical techniques for estimating price and
income elasticities.
The Economics of Addiction
In some cases, but sparingly and with great hesitation, the government decides to
overrule private adult decisions. These are cases of merit goods, whose
consumption is thought intrinsically worthwhile, and the opposite, which are
demerit goods, whose consumption is deemed harmful.
For these goods, we recognize that some consumption activities have such serious
effects that overriding individuals’ private decisions may be desirable.

The Paradox of Value

More than two centuries ago, in The Wealth of Nations, Adam Smith posed the
paradox of value: “Nothing is more useful than water; but it will scarce purchase
anything. A diamond, on the contrary, has scarce any value in use; but a very
great quantity of other goods may frequently be had in exchange for it.” In other
words, how is it that water, which is essential to life, has little value, while
diamonds, which are generally used for conspicuous consumption, command an
exalted price?
The more there is of a commodity, the less is the relative desirability of its last little
unit. It is therefore clear why water has a low price and why an absolute necessity
like air can become a free good. In both cases, it is the large quantities that pull the
marginal utilities so far down and thus reduce the prices of these vital commodities.

Consumer Surplus
The paradox of value emphasizes that the recorded monetary value of a good
(measured by price times quantity) may be a misleading indicator of the total
economic value of that good. The measured economic value of the air we breathe
is zero, yet air’s contribution to welfare is immeasurably large. The gap between
the total utility of a good and its total market value is called consumer surplus.
The surplus arises because we “receive more than we pay for” as a result of the
law of diminishing marginal utility.
Because consumers pay the price of the last unit for all units consumed, they enjoy
a surplus of utility over cost. Consumer surplus measures the extra value that
consumers receive above what they pay for a commodity.

Applications of Consumer Surplus

The concept of consumer surplus is useful in helping evaluate many government
decisions.
Economists use consumer surplus when they are performing a cost-benefit
analysis, which attempts to determine the costs and benefits of a government
program.
Generally, an economist would recommend that a free road should be built if its
total consumer surplus exceeds its costs. Similar analyses have been used for
environmental questions such as whether to preserve wilderness areas for
recreation or whether to require new pollution-abatement equipment.
The concept of consumer surplus also points to the enormous privilege enjoyed by
citizens of modern societies. Each of us enjoys a vast array of enormously valuable
goods that can be bought at low prices