Topic 2

Theory of Consumer Choice and Elasticity

Chapter #2, 3

1

EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

Consumer Demand

• Consumer demand accounts for the total quantity of a good or service purchased over a specific period of time.

• The first law of demand states that as the price of a good or service is lowered, consumers would demand a larger quantity.

2EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

Consumer Demand Curve

D

DP ($)

$100

$50

126 Quantity of Cinema Tickets


Marginal Utility Theory - The Law of Diminishing Marginal Utility

• This theory of consumer choice is based on measuring the utility derived from consuming a good, using cardinal numbers.

• In measuring satisfaction in this way the law of diminishing marginal utility is encountered.

• The law states, that as a consumer increases consumption of a good or a service, the additional satisfaction derived from the consumption of each successive unit will diminish.


Units of Good X Consumed

Total Utility

Marginal Utility

0 01 150 1502 250 1003 330 804 380 505 400 20

• The third column shows marginal utility which is the change in total utility whenever an additional unit is consumed.

• As can be seen, marginal utility declines as consumption increases, thus demonstrating the law of diminishing marginal utility.


Marginal Utility per Dollar

• If consuming an extra unit of Good X which costs $3, increases utility by 150 utils, then its marginal utility to price ratio is given as:

• That is, for every dollar devoted towards purchasing Good X, 50 utils of satisfaction are gained.

dollar.perutils50$3

150

Price

UtilityMarginal


Choice based on Marginal Utility per Dollar

• In terms of making a choice if Good X has a higher utility to price ratio than Good Y, the consumer would rate Good X ahead of Good Y and choose to consume more of that good.

• Buy more of Good X and less of Good Y

Y

Y

X

X

ice

UtilityinalM

ice

UtilityinalM

Pr

arg

Pr

arg



• If Good Y has a higher utility to price ratio than Good X, the consumer would give Good Y a higher rating than Good X and would thus opt to purchase an increased quantity of Good Y.

• Buy more of Good Y and less of Good XYPrice

YUtilityMarginal

XPriceXUtilityMarginal


Equi-Marginal Utility condition

• If the two goods X and Y are rated identically by the consumer in terms of their marginal utility to price ratios there would be no justification for the consumer to choose to consume more of either Good X or Good Y.

YPriceYUtilityMarginal

XPriceXUtilityMarginal


Equi-Marginal Utility condition.

• The consumer is said to be in equilibrium with

respect to the consumption of Goods X and Y.

• This consumer equilibrium under marginal

utility approach is known as the Equi-Marginal

Utility condition.



Quantity ofhot dogs

TotalUtility

MarginalUtility

Quantity ofHamburgers

TotalUtility

MarginalUtility

0 0 0 0

1 250 250 1 300 300

2 450 200 2 570 270

3 640 190 3 820 250

4 790 150 4 1060 240

5 900 110 5 1290 230



Quantity of hot dogs

Marginal Utility/Price

Quantity of hamburgers


0 0

1 25 1 15

2 20 2 13.5

3 19 3 12.5

4 15 4 12

5 11 5 11.5

The consumer achieves equilibrium in consumption when 4 hot dogs and 1 hamburger are consumed.



Quantity of hot dog sandwiches


Quantity of hamburgers sandwiches


0 01 25 1 23.12 20 2 22.53 19 3 20.84 15 4 205 11 5 19.2

If the price of hamburgers is lowered to $12, then the new marginal utility to price ratios would be as shown in the table.This shows that the consumer achieves equilibrium when 2 hot dogs and 4 hamburgers are consumed.


First Law of Demand

Quantity of Hamburgers

Price

1 4

20

10

D

D

Therefore as the price of hamburgers is lowered from $20 to $12, the quantity demanded increases from 1 unit to 4 units. This depicts the inverse relationship between the price of a good and the quantity demanded as represented by the demand curve in the figure. 14EDWARD BAHAW - Economic Principles

and Their Application to Business (ABE)

Specimen Paper – Question 2

• Q2 (a) (i) Define the term marginal utility. (3 marks)

• (iii) Explain the relationship between the individual demand curve in part (ii) and the concept of marginal utility. (3 marks)


June 2008 – Question 1

Q1 State whether each of the following statements (a-e) is TRUE or FALSE.

Explain your answer, using diagrams where appropriate.

(b) “Diminishing marginal utility means that an individual’s total utility (or satisfaction) always decreases with the consumption of an extra unit of a good.” (5 marks)


Changes in Price and Movements along the Demand Curve

• Movements along the demand curve are brought about by a change in price of the good or service.

• A fall in price resulting in an increased quantity demanded which is termed an extension of demand.

• An increase in price resulting in a decreased quantity demanded which is termed a contraction of demand.


Increase in Price (Contraction)

D

D

A

B

P2

P1

P

Q1Q2 Q


Decrease in Price (Extension)P

D

D

X

YP2

P1

Q1 Q2 QQ19EDWARD BAHAW - Economic Principles


Conditions of Demand - Shifts of the Demand Curve

These are any other factors which affect demand other than price of the good in question. It include factors such as:

• Consumer’s Income• Price of other goods• Advertising• Consumer tastes


Changes in other Factions which affect demand - Shifts of the

Demand Curve• An increase in demand which is shown by a

rightward shift indicates that an increased

quantity is demanded at all price levels.

• A decrease in demand which is shown by a

leftward shift indicates that a decreased

quantity is demanded at all price levels. 21EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

Increase in demand

P ($)

D1

D1

Quantity

D2

D2

O


Decrease in demand

D2

D2

D1

D1

P ($)

QuantityO


Price Elasticity of Demand (PED)

Price elasticity of demand can be defined as a measure

of the degree of responsiveness of the quantity

demanded of a product to changes in its price. This is

calculated by dividing the percentage change in

quantity by the percentage change in price.


Price Elasticity of Demand (PED)

AgoodofpriceP

AgoodofquantityQwhere

P

QPED

A

A

A

A

%

%


P1 Q1 P2 Q2 % ΔP % ΔQ P.E.D. Category

$100 900 $90 1350 Elastic

$100 900 $90 990 Unitary

$100 900 $90 909 Inelastic

Fill in the blank columns of the table


P1 Q1 TR1 P2 Q2 TR2 P.E.D. Category

$100 900 $90 1350 Elastic

$100 900 $90 990 Unitary

$100 900 $90 909 Inelastic

Fill in the blank columns of the table


Use of P.E.D.

• Price elasticity used by the entrepreneur, in

formulating pricing strategies.

• If demand is found to be price elastic, a viable

action, is to lower prices.

• This would increase consumer’s expenditure on

the product and increase the firm’s total revenue.


Giffen Good

• This an exception to the first law of demand.

• As price increases, an increases quantity is

purchased.

• For these goods price elasticity of demand is

positive.


Income Elasticity of Demand (YED)

Income elasticity of demand can be defined as a

measure of the degree of responsiveness of the

quantity demanded of a product to changes in its

consumer’s income. This is calculated by dividing the

percentage change in quantity by the percentage

change in income30EDWARD BAHAW - Economic Principles


Income Elasticity of Demand (YED)

AgoodofQuantityQ

IncomesConsumerYwhere

Y

QYED

A

A

'

%

%


Categories of Y.E.D

• YED > 0 Positive income elasticity for normal

goods

• YED = 0 Zero income elasticity for constant

demand

• YED < 0 Negative income elasticity for inferior

goods32EDWARD BAHAW - Economic Principles


Luxury Goods vs Necessities

• A luxury good has an income elasticity of

demand of greater than 1.

• A necessity has an income elasticity of

demand is less than 1.


Cross Elasticity of Demand (XED)

Cross elasticity of demand can be defined as a measure

of the degree of responsiveness of the quantity

demanded of one product (Good A) to changes in the

price of another product (Good B).


Cross Elasticity of Demand (XED)

BgoodofpriceP

AgoodofquantityQwhere

P

QXED

B

A

B

A

%

%


Categories of X.E.D

• 0 < XED < ∞ when Good A and Good B are

substitutes

• XED = 0 when there is no relationship

between Good A and Good B

• -∞ < XED < 0 when Good A and Good B are

complementary.36EDWARD BAHAW - Economic Principles


BADS• In economics, a bad is a physical object that

lowers a consumer's level of happiness.• Garbage is an example of a bad. • A bad is the opposite of a good which gives

the consumer satisfaction.• A person would pay to consume a good.• A person would have to be paid to consume a

bad.


Specimen Paper – Question 2b(i) Write out, defining all terms, the formula for the

own price elasticity of demand. (3 marks)(ii) The price and quantity demanded of good Z were

recorded over two periods and are reported in the table below. Given the information in the table, use the formula in part (i) to calculate the elasticity of demand for good Z.


Specimen Paper – Question 2c

(i) Draw a diagram of a linear demand curve

and the associated marginal revenue curve.

(ii) Indicate on your diagram the points or

regions of the demand curve for which

demand is elastic, unit elastic and inelastic.


June 2008 Question 4a

Write out the formula for each of the following:

(i) the own-price elasticity of demand for a good X;

(ii) the cross-price elasticity of demand for a good X

with respect to a related good Y;

(iii) the income elasticity of demand for a good X.

(9 marks)40EDWARD BAHAW - Economic Principles


June 2008 Question 4b

Explain the meaning of each of the following terms, using the relevant measure of

elasticity from part (a) to support your answer:(i) a Giffen good;(ii) a normal good;(iii) an inferior good;(iv) complementary goods. (16 marks)


Dec 2007 Question 2a

Using an appropriate diagram: explain how the

market demand for a good changes with a

change in its own price (5 marks)

Explain why the market demand curve for a

normal good slopes downwards. (6 marks)

Dec 2006 Question 2a


Topic 2

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