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Chapter 3; Consumer Behaviour, Demand and Elasticity Learning Outcomes: Understand the relationship between consumer demand and output decisions Relate the concept of satisfaction and demand for consumer goods Identify and analyse equilibrium in consumer demand Appreciate how price elasticity of demand influences price and output decisions

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Utility • Utility is the satisfaction derived from the consumption of a good measured in numbers. • This analysis of consumer demand is based on the presumption that the amount of utility generated from the consumption of a good can be explicitly measured." • Marginal utility is the additional utility derived from consuming each additional unit of the good.

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Total and Marginal Utility

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The Law of Diminishing Marginal Utility • The law of diminishing marginal utility states that marginal utility, or the extra utility obtained from consuming a good, decreases as the quantity consumed increases. In essence, each additional good consumed is less satisfying than the previous one. • If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As such, the demand price declines.

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Indifference Curves • Here we look at the analysis of the indifference curves. This curve suggests that a consumer will be "indifferent" between consuming any combination of the two goods anywhere on the curve. • Indifference curve analysis relies on a relative ranking of preferences between two goods rather than the absolute measurement of utility derived from the consumption of a particular good.. McGraw-Hill/Irwin

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An Indifference curve

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Demand and Elasticity

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Demand Demand is the willingness and ability to buy a range of quantities of a good at a range of prices, during a given time period. The following factors affect demand The price of the good and substitutes Consumers’ disposable incomes Advertising of this product Rates of interest.

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Demand Curve • The demand curve is a graphic representation of the market demand function and the Law of Demand. The demand curve represents the quantities of a good or service that consumers are willing and able to purchase at various prices. • The demand curve slopes down from left to right based on the Law of Demand. As the price of good increases, consumers switch purchases to other goods, reducing the quantity demanded. McGraw-Hill/Irwin

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The Demand Curve

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Price Elasticity of Demand • The law of demand mentioned above states that when a price of that product changes it causes an inverse change in the amount of quantity demanded of that good, ceteris paribus. • The theory of elasticity states the approximated magnitude of how much change in demand will occur given a percentage change in its price level. Therefore the price elasticity of demand can be referred to as the percentage change in quantity demanded of a good due to a one percent change in its price level. McGraw-Hill/Irwin

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Formula

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Interpretation If elasticity is greater or equal to one, the demand curve is considered to be elastic. If it is less than one, the demand curve is said to be inelastic.

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Elasticity and Revenue • The theory of demand suggests that when a firm tries to maximise revenue but not operating at the midpoint of its demand curve should raise price if demand is inelastic and should lower price if demand is elastic. • If demand is inelastic, customers are not responsive. However, if demand is elastic, customers are very sensitive. • Hence, as a manager, you should raise price only when demand is inelastic which means you are to the right of the demand curve midpoint. •

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Note these Points • Any revenue changes in response to price changes will depend upon elasticity. • When elasticity is greater than one price changes and revenue changes are inverse. • When elasticity is less than one, price changes and revenue changes are direct.

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Income Elasticity of Demand • Income elasticity of demand is referred to as the ratio that measures the relative responsiveness of demand due to a change in the income of consumers. • Income Elasticity of Demand • = % change in Qd / % change in Price

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Income elasticity of demand • Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. A very high income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. A very low price elasticity implies just the opposite, that changes in a consumer's income has little influence on demand. McGraw-Hill/Irwin

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Income elasticity of demand

• If income elasticity of demand is greater than one, demand for the product is considered to have high income elasticity. If however income elasticity is less than one, demand is considered to be income inelastic. • Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. McGraw-Hill/Irwin

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Income elasticity of demand • With some goods and services, we may actually notice a decrease in demand as income increases. These are considered to be inferior goods and will be dropped by a consumer who receives a salary increase. ( e.g) • Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero. These goods and services are considered necessities. McGraw-Hill/Irwin

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Cross-Price Elasticity of Demand • The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another. • If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. • Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall.

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Cross-Price Elasticity of Demand The cross price elasticity of demand can be measured as follows: • Cross Elasticity of demand = • percentage change in Qd for Good X • percentage change in price of Good Y

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Market Supply • Supply reflects the behaviour of producers. The supply curve indicates the quantities of a good or service that firms are willing to produce at different price levels, ceteris paribus. The law of supply states that any increase in the price level will lead to an increase in the quantity supplied of goods and services, all other things remaining equal. Hence, there exists a positive relationship between the price level and quantity supplied implying the supply curve is an upward-sloping curve. McGraw-Hill/Irwin

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Movements along the Supply Curve

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Improved Technologies • Suppose advanced transport technologies and innovations are introduced in the production of motorcars, all other things remaining constant.. • An increase in technology will lead to increased production, and hence shifts the supply curve to the right. • Alternatively, increases in wages, which forms part of a firms costs of production will cause the supply curve to shift to the left at each price level. McGraw-Hill/Irwin

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Shifts in the Market Supply Curve

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Market Equilibrium

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Increased Demand and Equilibrium

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Decreased supply and equilibrium

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End of Chapter 3

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