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Background Background to Demand to Demand
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BackgroundBackgroundto Demandto Demand
Background to Demand
Marginal Utility Theory
Total and marginal utility meaning of total utility
marginal utility: TU/Qdiminishing marginal utility
total and marginal utility curves
MARGINAL UTILITY THEORY
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TUin utils
0123456
07
1113141413
Util
ity (u
tils)
Packets of crisps consumed (per day)
Darren’s utility from consuming crisps (daily)
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TUin utils
0123456
07
1113141413
Util
ity (u
tils)
Packets of crisps consumed (per day)
TU
Darren’s utility from consuming crisps (daily)
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TUin utils
0123456
07
1113141413
MUin utils
-74210
-1
Util
ity (u
tils)
Packets of crisps consumed (per day)
TU
Darren’s utility from consuming crisps (daily)
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TUin utils
0123456
07
1113141413
MUin utils
-74210
-1
Util
ity (u
tils)
Packets of crisps consumed (per day)
TU
MU
Darren’s utility from consuming crisps (daily)
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6MU
TU = 2
Q = 1
MU = TU / Q
Util
ity (u
tils)
Packets of crisps consumed (per day)
TU
Darren’s utility from consuming crisps (daily)
-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6MU
MU = TU / Q = 2/1 = 2
Util
ity (u
tils)
Packets of crisps consumed (per day)
TU
TU = 2
Q = 1
Darren’s utility from consuming crisps (daily)
The optimum level of consumption: the one-commodity version consumer surplus (total and marginal)
marginal consumer surplus: MU – P
total consumer surplus: TU – TE
MARGINAL UTILITY THEORY
MU
P1
Q1O
MU, P
Q
Consumer surplus
Totalconsumer
expenditureMU
P1
Q1O
MU, P
Q
Consumer surplus
Totalconsumer
expenditureMU
Total consumer surplus
P1
Q1
MU, P
QO
Consumer surplus
The optimum level of consumption: the one-commodity version
consumer surplus (total and marginal)
marginal consumer surplus: MU – P
total consumer surplus: TU – TE
maximising consumer surplus: P = MU
Marginal utility and the demand curve
MARGINAL UTILITY THEORY
MU = D
MU, P
QO Q1
P1a
Consumption at Q1
where P1 = MU
Deriving an individual person’s demand curve
Q2O
P1
Q1
a
P2
b
Consumption at Q2
where P2 = MU
MU, P
Q
MU = D
Deriving an individual person’s demand curve
P2
Q2O
P1
Q3Q1
a
P3c
Consumption at Q3
where P3 = MU
b
MU, P
Q
MU = D
Deriving an individual person’s demand curve
Limitations of the one-commodity version marginal utility affected by consumption of
other goods marginal utility of money not constant
Optimum combination of goods the equi-marginal principle
MUA/MUB = PA/PB
deriving a demand curve
MARGINAL UTILITY THEORY
Background to Demand
Risk, Uncertainty and Insurance
Demand under conditions of risk and uncertainty defining risk and uncertainty types of odds risk attitudes
Diminishing marginal utility of income and attitudes towards risk taking
RISK, UNCERTAINTY AND INSURANCE
TU
5000 10 000 15 0000
Income (£)
Tota
l util
ity
U1
Total utility of income
a
TU
5000 10 000 15 0000
U2
U1
a
b
Income (£)
Tota
l util
ityTotal utility of income
TU
5000 10 000 15 0000
U3
U2
U1
a
b
c
Income (£)
Tota
l util
ityTotal utility of income
TU
5000 10 000 15 0000 8000
U3
U2
U1
U4
a
b
c
Income (£)
Tota
l util
ity
d
Total utility of income
Insurance: a way of removing risks
How insurers spread risks the law of large numbers
importance of the independence of risks
Problems for insurers adverse selection
moral hazard
RISK, UNCERTAINTY AND INSURANCE
Background to Demand
Indifference Analysis
Indifference curves constructing an indifference curve
INDIFFERENCE ANALYSIS
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Combinations of pears andoranges that Clive likes
the same amount as10 pears and 13 oranges
Constructing an indifference curve
02468
1012141618202224262830
0 2 4 6 8 10 12 14 16 18 20 22
Pea
rs
Oranges
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Constructing an indifference curve
aP
ears
Oranges
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Constructing an indifference curve
02468
1012141618202224262830
0 2 4 6 8 10 12 14 16 18 20 22
a
b
Pea
rs
Oranges
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Constructing an indifference curve
02468
1012141618202224262830
0 2 4 6 8 10 12 14 16 18 20 22
a
b
c
d
ef
g
Pea
rs
Oranges
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Constructing an indifference curve
02468
1012141618202224262830
0 2 4 6 8 10 12 14 16 18 20 22
Indifference curves constructing an indifference curve the shape of an indifference curve diminishing marginal rate of substitution
INDIFFERENCE ANALYSIS
0
10
20
30
0 10 206
26
7
Uni
ts o
f goo
d Y
Units of good X
a
bY = 4
X = 1
MRS = 4
MRS = Y/X
Deriving the marginal rate of substitution (MRS)
0
10
20
30
0 10 20
a
b
Uni
ts o
f goo
d Y
Units of good X
26
6 7
d
Y = 4
X = 1
Y = 1
X = 1
MRS = 1
MRS = 4
13 14
9
c
MRS = Y/X
Deriving the marginal rate of substitution (MRS)
Indifference curves constructing an indifference curve the shape of an indifference curve diminishing marginal rate of substitution an indifference map
INDIFFERENCE ANALYSIS
0
10
20
30
0 10 20
Uni
ts o
f goo
d Y
Units of good X
I1I2
I3
I4
I5
An indifference map
Indifference curves constructing an indifference curve the shape of an indifference curve diminishing marginal rate of substitution an indifference map
The budget line constructing a budget line
INDIFFERENCE ANALYSIS
Units ofgood X
0 51015
Units ofgood Y
302010 0
Assumptions
PX = £2PY = £1
Budget = £30
A budget line
Uni
ts o
f goo
d Y
Units of good X
a
Units ofgood X
0 51015
Units ofgood Y
302010 0
Assumptions
PX = £2PY = £1
Budget = £30
Point onbudget line
a
A budget line
0
10
20
30
0 5 10 15 20
Uni
ts o
f goo
d Y
Units of good X
a
b
Units ofgood X
0 51015
Units ofgood Y
302010 0
Point onbudget line
ab
Assumptions
PX = £2PY = £1
Budget = £30
A budget line
0
10
20
30
0 5 10 15 20
Uni
ts o
f goo
d Y
Units of good X
a
b
c
Units ofgood X
0 51015
Units ofgood Y
302010 0
Point onbudget line
abc
Assumptions
PX = £2PY = £1
Budget = £30
A budget line
0
10
20
30
0 5 10 15 20
Uni
ts o
f goo
d Y
Units of good X
a
b
c
d
Units ofgood X
0 51015
Units ofgood Y
302010 0
Point onbudget line
abcd
Assumptions
PX = £2PY = £1
Budget = £30
A budget line
0
10
20
30
0 5 10 15 20
Indifference curves constructing an indifference curve the shape of an indifference curve diminishing marginal rate of substitution an indifference map
The budget line constructing a budget line effect of a change in income
INDIFFERENCE ANALYSIS
Uni
ts o
f goo
d Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £30
Effect of an increase in income on the budget line
0
10
20
30
40
0 5 10 15 20
Uni
ts o
f goo
d Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £40
Budget = £40
Budget = £30
16
7
0
10
20
30
40
0 5 10 15 20
m
n
Effect of an increase in income on the budget line
Indifference curves constructing an indifference curve the shape of an indifference curve diminishing marginal rate of substitution an indifference map
The budget line constructing a budget line effect of a change in income effect of a change in price
INDIFFERENCE ANALYSIS
0
10
20
30
0 5 10 15 20 25 30
Effect on the budget line of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £30
0
10
20
30
0 5 10 15 20 25 30
Effect on the budget line of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £30
0
10
20
30
0 5 10 15 20 25 30
Effect on the budget line of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
Effect on the budget line of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
B1B2
a
b0
10
20
30
0 5 10 15 20 25 30
c
The optimum consumption point
INDIFFERENCE ANALYSIS
Finding the optimum consumptionU
nits
of g
ood
Y
Units of good XO
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
Units of good XO
Finding the optimum consumption
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
OUnits of good X
Budget line
Finding the optimum consumption
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
OUnits of good X
r
v
s
u
Y1
X1
t
Finding the optimum consumption
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
INDIFFERENCE ANALYSIS
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
OUnits of good X
r
v
s
u
Y1
X1
t
Finding the optimum consumption
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
The effect of a change in income
INDIFFERENCE ANALYSIS
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
The effect of a change in income the income–consumption curve
INDIFFERENCE ANALYSIS
Uni
ts o
f goo
d Y
OUnits of good X
B1
Effect on consumption of a change in income
I1
a
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 I1
Effect on consumption of a change in income
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 B3 B4 I1
I3I4
Effect on consumption of a change in income
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 B3 B4 I1
I3I4
Income-consumption curve
Effect on consumption of a change in income
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
The effect of a change in income the income–consumption curve the Engel curve
INDIFFERENCE ANALYSIS
Bre
ad
B1 B2 B3
I3I2I1
CDs
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurve
CDs
Bre
ad
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurve
CDs
CDs
Bre
adIn
com
e (£
)
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb1
Qcd1
a
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb1
Y1
Qcd1
Qcd1
a
a
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb2Qb1
Y2
Y1
Qcd2Qcd1
Qcd2Qcd1
ab
ab
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb3Qb2Qb1
Y3
Y2
Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2
Qcd1
ab
c
ab
c
Deriving an Engel curve from an income-consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb3Qb2Qb1
Y3
Y2
Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2
Qcd1
Engel curve
ab
c
ab
c
Deriving an Engel curve from an income-consumption curve
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
The effect of a change in income the income–consumption curve the Engel curve income elasticity of demand and the
income–consumption curve
INDIFFERENCE ANALYSIS
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb3Qb2Qb1
Y3
Y2
Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2
Qcd1
Engel curve
ab
c
ab
c
Deriving an Engel curve from an income-consumption curve
The optimum consumption point equating the marginal rate of substitution
with the price ratioMRS = MUA/MUB = PA/PB
The effect of a change in income the income–consumption curve the Engel curve income elasticity of demand and the
income–consumption curve the effect of a rise in income on the demand
for an inferior good
INDIFFERENCE ANALYSIS
Effect of a rise in income on the demand for an inferior goodU
nits
of g
ood
Y(n
orm
al g
ood)
Units of good X(inferior good)
O
I1B1
a
Uni
ts o
f goo
d Y
(nor
mal
goo
d)
O
I2
I1B1 B2
a
b
Units of good X(inferior good)
Effect of a rise in income on the demand for an inferior good
Uni
ts o
f goo
d Y
(nor
mal
goo
d)
O
Income-consumption curve
I2
I1B1 B2
a
b
Units of good X(inferior good)
Effect of a rise in income on the demand for an inferior good
The effect of changes in price the price–consumption curve
INDIFFERENCE ANALYSIS
0
10
20
30
0 5 10 15 20 25 30
Assumptions
PX = £2PY = £1
Budget = £30
Effect of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Uni
ts o
f goo
d Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £30
B1 I10
10
20
30
0 5 10 15 20 25 30
j
Effect of a fall in the price of good X
Uni
ts o
f goo
d Y
Units of good X
B1 I1
j
Assumptions
PX = £1PY = £1
Budget = £30
0
10
20
30
0 5 10 15 20 25 30
Effect of a fall in the price of good X
Uni
ts o
f goo
d Y
Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
B1 I1 B2
a
j
0
10
20
30
0 5 10 15 20 25 30
I2
k
Effect of a fall in the price of good X
0
10
20
30
0 5 10 15 20 25 30
Uni
ts o
f goo
d Y
Units of good X
B1 I1 B2
a
j
I2
Price-consumption curve
k
Effect of a fall in the price of good X
The effect of changes in price the price–consumption curve deriving the individual's demand curve
INDIFFERENCE ANALYSIS
Deriving a demand curve from a price-consumption curve
B1I1
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a
I2
Deriving a demand curve from a price-consumption curve
B1 B2
I1
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a b
Fall in theprice of X
I2
Deriving a demand curve from a price-consumption curve
B1 B2
I1
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a b
Further falls inthe price of X
Deriving a demand curve from a price-consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a bc d
Further falls inthe price of X
Deriving a demand curve from a price-consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
Price-consumptioncurve
a bc d
Deriving a demand curve from a price-consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Pric
e of
goo
d X
Units of good X
P1
Q1
a
Deriving a demand curve from a price-consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Pric
e of
goo
d X
Units of good X
a
Demand
P1
P2
P3P4
Q1 Q2 Q3 Q4
b
cd
The effect of changes in price the price–consumption curve deriving the individual's demand curve
Income and substitution effects of a price change
INDIFFERENCE ANALYSIS
The effect of changes in price the price–consumption curve deriving the individual's demand curve
Income and substitution effects of a price change a normal good
INDIFFERENCE ANALYSIS
Uni
ts o
f goo
d Y
I1I2I3I4I5I6B1
f
QX1
Income and substitution effects: normal good
Units of Good X
Uni
ts o
f goo
d Y
I1I2I3I4I5I6B2
h
B1
QX1
f
Rise in the price of good X
Income and substitution effects: normal good
Units of Good XQX3
Uni
ts o
f goo
d Y
B2
Substitutioneffect
B1
QX1
h
fI1I2I3I4I5I6
QX2
B1a
Substitution effectof the price rise
g
Income and substitution effects: normal good
Units of Good XQX3
Units of Good X
Uni
ts o
f goo
d Y
I1I2I3I4I5I6
Substitutioneffect
Income
effect
QX1
h
f
g
B2 B1
QX2QX3
B1a
Income effect ofthe price rise
Income and substitution effects: normal good
The effect of changes in price the price–consumption curve deriving the individual's demand curve
Income and substitution effects of a price change a normal good an inferior good
INDIFFERENCE ANALYSIS
Units of Good X
Uni
ts o
f goo
d Y
B1
Income and substitution effects: Inferior (non-Giffen) good
f
QX1
I1
I2
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
QX3
I1
I2
Rise in the price of good X
h
B1
Income and substitution effects: Inferior (non-Giffen) good
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
h
QX2
I1
I2
Substitution effect
B1a
Substitution effectof the price rise
B1
Income and substitution effects: Inferior (non-Giffen) good
g
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
g
QX2QX3
I1
I2
Substitution effect
h
Income effect
B1a
Income effect ofthe price rise
B1
Income and substitution effects: Inferior (non-Giffen) good
The effect of changes in price the price–consumption curve deriving the individual's demand curve
Income and substitution effects of a price change a normal good an inferior good a Giffen good (a special type of inferior
good)
INDIFFERENCE ANALYSIS
Units of Good X
Uni
ts o
f goo
d Y
B1
Income and substitution effects: Giffen good
f
QX1
I1
I2
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
QX3
I1
I2
Rise in the price of good X
h
B1
Income and substitution effects: Giffen good
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
h
QX3
I1
I2QX2
B1a
g
Substitution effect
Substitution effectof the price rise
B1
Income and substitution effects: Giffen good
Units of Good X
Uni
ts o
f goo
d Y
f
QX1
B2
h
QX3
I1
I2
g
QX2Substitution effect
Income effect
Income effect ofthe price rise
B1
Income and substitution effects: Giffen good
B1a
The effect of a change in price on the demand for other goods
The usefulness of indifference analysis
superiority of using ordinal measures
limitations of indifference analysis
INDIFFERENCE ANALYSIS
