Consumer Behavior &

DEMAND Ms S Chattopadhyay PGT Economics KV BallygungE

Content

• Consumer’s Equilibrium• Theory of Demand • Price Elasticity of Demand

CONSUMER’s EQUILIBRIUM

CONSUMER’s EQUILIBRIUM

• BASIC CONCEPTS• Consumer’s Equilibrium Using

Marginal Utility Analysis • Consumer’s Equilibrium by

Indifference Curve Approach

Basic concepts I

• Utility - Want satisfying power of a commodity .

• Total Utility - Total satisfaction obtained by a consumer from consuming given amount of a commodity .

• Marginal Utility - Change in total utility resulting from the change in consumption by one unit. MUn = TUn – TUn-1 .

Basic concepts II• Law of Diminishing MU – As we consume

more and more units of a commodity , the utility derived from each successive unit goes on diminishing.

• Assumption – LDMU is based on certain basic assumptions like Rationality of the consumer, Continuous consumption, Uniform quality of the commodity consumed.

Basic concepts III• Relation : TU & MU

When TU increases at a diminishing rate , MU falls.

( Upto 4th Unit ) When TU reaches its maximum & constant, MU = 0 ( At

5th Unit ) When TU falls, MU < 0 ( Above 5th Unit )

Unit of consumption

TU

MU

01 20 2002 36 1603 46 1004 50 0405 50 0006 44 06

Consumer’s Equilibrium by marginal utility analysis( Cardinal Approach )

• Consumer Equilibrium : Meaning The situation when a consumer is having

maximum satisfaction with given income and has no tendency to change his way of existing expenditure.

• Condition of consumer equilibrium – In case of single commodity :

MUx in terms of money = Px ( x : commodity )

i.e MUx / MUm = PX ( MUm : MU of money )

• Consumer Equilibrium (in case of single commodity) Unit of

XPrice of X MU x MUx / Mum

MUm = 1Mux/MUm - Px Remarks

1

2

10

10

20

16

20 / 1 = 20

16/1 = 16

20 – 10 = 10

16 – 10 = 6

MUx/MUm > PxIncrease in

consumption

3 10 10 10/1 = 10

10-10= 0

MUx/MUm = Px

Consumer’s Equilibrium

4 5

1010

40

4/1 = 40 / 1 = 0

4 – 10 = -60 – 10 = -10

MUx/MUm < PxDecrease in consumption

• Conditions of Consumer Equilibrium – In case of Two commodities ( X & Y ) :

MU of last rupee spent on each commodity spent

is same i.e. MUX / PX = MUY / PY Subject to Px . X + Py . Y = M M : Money income.

• Consumer Equilibrium ( In case of Two comm)Commodity X Commodity Y

Unit X MUx Px Mux / Px

Unit Y MUy Py MUy / Py

1 100 10 10 1 24 2 12

2 80 10 8 2 22 2 11

3 60 10 6 3 20 2 10 4 40 10 4 4 18 2 9

5 20 10 2 5 16 2 86 0 10 0 6 14 2 7

* Money Income (M) of the consumer is Rs 30.1. At X=1 & Y= 3, MUx / Px = MUy / Py but (Exp on X + Exp on Y ) ≠ M 2. At X= 2 & Y= 5 , MUx / Px = MUy / Py and (Exp on X + Exp on Y ) = M (Equilibrium ) 3. If MUx/Px > MUy/Py , the consumer gets more MU from last rupee spent on X as

compared to Y. He will buy more of X and less of Y till MUx/Px = MUy/Py.4. If MUx/Px < MUy/Py, the consumer gets more MU from the last rupee spent on Y as

compared to X. He will buy more of X and less of Y till MUx/Px = MUy/Py .

Consumer’s Equilibrium by Indifference Curve Approach ( Ordinal Approach )

• Indifference Curve : Meaning A curve showing different combinations of two

goods which give equal satisfaction to the consumer.

• Indifference Map : Meaning A family of indifference curves is called an

Indifference Map. Higher IC represents higher level of satisfaction.

• Monotonic Preference : Meaning

• A consumer’s preferences are monotonic if and only if between any two bundles, he prefers the bundle which has more of at least one of the goods and no less of the other good as compared in the other bundle.

• Example : Consumer prefers bundle (2,3) to bundles (2,2), (1,3) & (1,2).

• Monotonicity of preferences implies that a point above IC represents a bundle which is preferred to the bundle on IC

• Slope of Indifference Curve / Marginal Rate of Substitution (MRSxy)

(i) MRSxy – The amount of one good (Y) which a consumer is willing to sacrifice for an additional unit of the other good (X). The rate at which the consumer trades off Y for X.

(ii) The slope measures the substitution ratio between the two goods.

(iii) Slope of IC = Y / X = MRSxy

• Properties Of Indifference Curve

(i) An IC slopes downward – If the consumer wants to have more units of one good, he will have to reduce the consumption of other good in order to maintain the same level of satisfaction.

(ii) An IC is convex to the origin i.e. MRS is Diminishing – The consumer is willing to give up less and less unit of one good for an increment in the other (MU of the other falls with increase in consumption).

(iii) Two ICs do not intersect each other. (Explanation may be given with diagram)

• Budget Line • It shows all possible combinations of two goods that

a consumer can buy with given income & prices of the commodities.

• Budget Line : Px . X + Py . Y = M ( M : total income)• Slope of Budget Line = Px / Py i.e. the consumer can substitute good X for Y at the

rate of Px/Py. Qy A (0, M/Py) • Budget Line (AB)

B (M/Px, 0)

Qx

• Why is the slope of Budget Line represented by Price Ratio

• A point on budget line indicates a bundle which the consumer can purchase by spending his entire income. So, if he wants to have one more unit of one good ( say X) , he will have to give up some amount of the other good (say Y).

• Suppose price of good X is Rs 4 per unit (Px=4) & that of good Y is Rs 2 per unit (Py= 2). So to get one extra unit of X , he has to sacrifice 2 units of good Y.

• Slope of Budget Line = Unit sacrificed / Unit gained

• = 2 / 1• Price Ratio = Px / Py = 4 / 2 = 2/1• Thus, slope of Budget Line = Price ratio

• Shift in Budget Line • (i) Change in Income – when income rises

consumer can buy more of both the goods , the budget line shifts rightward (parallel shift - slope remains same as no change in price) & vice versa.

• (ii) Change in Price – ( change in slope)• Px falls / Px rises Py falls / Py rises• Qy A Qy A1 A Py falls Px falls A2 Qx Py rises

Qx B2 B B1 B

• Conditions of ConsumerEquilibrium(IC)

(i) Slope of IC = Slope of Budget Line i.e. MRSxy = Px / Py

(ii) Diminishing MRS

• Consumer Equilibrium with IC

• E : equilibrium point which shows the

combination at which Slope of Budget Line = Slope of IC i.e. Px / Py = MRSxy

• Consumer equilibrium with IC (contd…)

(i) if MRSxy > Px/Py, to obtain one more unit of X, the consumer is willing to sacrifice more unit of Y than what the market requires i.e. he is willing to pay more for X than the price prevailing in the market. As a result, he buys more of X & MRS falls till it becomes equal to the ratio of prices.

(ii) If MRSxy < Px/Py , to obtain one more unit of X , the consumer is willing to sacrifice lesser units of Y i.e. he is willing to pay less for X than the price prevailing in the market. As a result he buys less of X & more of Y & MRS rises till it becomes equal to the ratio of prices.

THEORY OF DEMAND

THEORY OF DEMAND • Basic Concepts• Determinants of Demand • Law of demand• Change in quantity demanded • Change in demand

Basic Concepts• Demand The quantity of a commodity the

consumer is willing to buy at a particular price during a particular period of time.

• Demand Schedule A tabular presentation of various quantities of a good that consumers are willing to buy at different prices Individual & Market Demand Schedule.

• Demand Curve A graphical presentation of various quantities of a good that consumers are willing to buy at different prices Individual & Market Demand Curve.

Determinants of Demand I• Price of the commodity – Inverse

relationship between price of the commodity & its quantity demanded.

• Prices of Related commodities – Two cases (i) Substitute Goods (eg. Tea& Coffee) – Direct relation between price of a commodity & demand for its substitute.

(ii) Complementary Goods (eg. Ink & Pen) – Inverse relation between price of a commodity & demand for its complementary good.

Determinants of Demand II• Income of the consumer – (Two cases) (i) Normal Good – Demand for the good increases with

increase in income of the consumer. Direct relation. (ii) Inferior Good – Demand for the good decreases with

increase in income of the consumer. Inverse relation.

. Taste & preferences of the consumer – Favourable changes in taste & preferences of the consumer increases demand for a commodity. Direct relation.

. Expectation of consumer about future change in price of the commodity – Direct relation

. Size of population – Direct relation.

Law of Demand• Statement – Other factors remaining same the

demand for a good is inversely related to its price.

• Example – Px 10 20 30 Qx 35 25 15 • Diagram – Inverse relation is represented by

downward sloping demand curve. Px

d Qx

Change in Quantity Demanded• Expansion of Demand – Other things remaining

same , demand for a commodity rises with fall in its price . Represented by downward movement along the demand curve. Eg. Px : 10 05 Qx : 15 20

• Contraction of Demand – Other things remaining same , demand for a commodity falls with rise in its price. Represented by upward movement along the demand curve. Eg. Px : 05 10 Qx : 20 15

• Diagram : Represented by the movement along the demand curve. Students should draw the diagram

Change In Demand (i) Increase in demand . Meaning : When higher quantity of a commodity is

demanded at the same price due to change in other determinants of demand.

. Example : Px 10 10 Qx 20 30 . Specific reasons : Change in determinants other

than the price of the commodity eg. Increase in Income, Rise in price of substitute good, Fall in price of complementary good, Favourable change in taste & preference of the consumer etc.

. Diagram : Represented by rightward shift of demand curve. (Students should draw the diagram.)

(ii) Decrease in demand . Meaning : When lower quantity of a

commodity is demanded at the same price due to change in other determinants of demand.

. Example : Px 10 10 Qx 30 20 . Specific reasons : Change in determinants

other than the price of the commodity eg. Decrease in Income, Fall in price of substitute good, Rise in price of complementary good, Unfavourable change in taste & preference of the consumer etc.

. Diagram : Represented by leftward shift of demand curve. Students should draw the diagram.

Price Elasticity of demand

Price Elasticity of demand• Meaning • Measurement of Price Elasticity of

Demand - Total Expenditure Method, Point Method & Percentage Method.

• Degrees of Elasticity of Demand• Factors affecting Price Elasticity of

Demand.

Price Elasticity of Demand• Meaning : It is a measure of degree of

responsiveness of demand for a commodity to change in its price.

Measurement of Price Elasticity of Demand I

• Total Expenditure Method Elasticity is measured on the basis of nature of change in total expenditure on the commodity due to change in its price.

SL If Price falls Description Ed Term Used1 Expenditure Increases Qty demanded rises in

greater proportionEd > 1 Elastic Demand

2 Expenditure remains constant

Qty demanded rises in the same proportion

Ed = 1 Unitary elastic demand

3 Expenditure falls Qty demanded rises in a lesser proportion

Ed < 1 Inelastic Demand

Measurement of Price Elasticity of Demand II

• Point Method • Elasticity of Demand = (Lower seg. / Upper seg.)

of demand curve • Price A (Ed = ∞) E(Ed >1)

C (Ed = 1 : C - Mid-point) D (Ed < 1)

B(Ed=0) Qty

Measurement of Price Elasticity of Demand III

• Percentage Method

• Ed = ( % change in Qty demanded / % change in Price) = ( change in Q / change in P ) X P/Q

• The absolute value of the coefficient of elasticity of demand ranges from Zero to Infinity.

Degrees of Elasticity of Demand Ed Type of

EdDescription Type of

GoodShape of Demand Curve

Ed = 0 PerfectlyInelastic

No change in Qty demanded due to change in price

Essentials of life

Vertical St Line

0 < Ed < 1 Inelastic % change in demand < % change in price

Necessities of life

Downward sloping steeper

Ed = 1 UnitaryElastic

% change in demand = % change in price

Normal goods

Rectangular hyperbola

1 < Ed < ∞ Elastic % change in demand > % change in price

Luxuries Downward sloping flatter

Ed = ∞ PerfectlyElastic

Infinite change in demand without any change in price

Imaginary (under PC)

Horizontal

Factors affecting Price Elasticity of Demand

• Availability of close substitutes in market

• Nature of commodity – necessary / luxury

• Income level of the consumers.

• Proportion of total expenditure spent on the product.

• Time period needed to find substitute

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