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Econ 10 - 951

Econ 10 - 951. UNC-Chapel Hill Spring 2001. Lecture 7 Consumer Theory 02/01/2000. 1. The Fundamentals of Consumer Choice. Fundamentals of Consumer Choice. Consumers make choices purposefully. One good can be substituted for another.

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Econ 10 - 951

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  1. Econ 10 - 951 UNC-Chapel Hill Spring 2001 Lecture 7 Consumer Theory 02/01/2000

  2. 1. The Fundamentals of Consumer Choice

  3. Fundamentals of Consumer Choice • Consumers make choices purposefully. • One good can be substituted for another. • Consumers must make decisions without perfect information, but knowledge and past experience will help. • Limited income necessitates choice.

  4. Fundamentals of Consumer Choice • The law of diminishing marginal utility applies: • As the rate of consumption increases, the marginal utility derived from consuming additional units of a good will decline.

  5. The Demand Curve • The height of an individual's demand curve is equal to the maximum price the consumer would be willing to pay for that unit—its marginal benefit. • A consumer's willingness to pay for a unit of a good is directly related to the utility derived from consumption of the unit.

  6. The Demand Curve • The law of diminishing marginal utility implies that a consumer's marginal benefit, and thus the height of their demand curve, falls with the rate of consumption.

  7. MB1 MB2 MB3 Price = MB4 d = MB < < < MB4 MB3 MB2 MB1 because < < < MU4 MU3 MU2 MU1 The Demand Curve Price • An individual’s demand curve, Jones’s demand for frozen pizzas in this case, reflects the law of diminishing marginal utility. $3.50 $3.00 • Because marginal utility (MU) falls with increased consumption, so does the consumer’s maximum willingness to pay -- marginal benefit (MB). $2.50 $2.00 • A consumer will purchase until MB = Price . . . so at $2.50 Jones would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded triangle (the area above theprice line and below the demand curve). 3 1 2 3 4 Quantity of frozen pizzasper week

  8. MUB MUN MUA PB PN PA Consumer Equilibrium With Many Goods • Each consumer will maximize his/her satisfaction by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility. = = . . . =

  9. Price Changes and Consumer Choice • The demand curve shows the amount of a product that consumers would be willing to purchase at alternative prices during a specific time period. • The law of demand states that the amount of a product purchased is inversely related to its price.

  10. Price Changes and Consumer Choice • Reasons for the downward slope of a demand curve. • Substitution effect: as the price of a product declines, consumers will buy more of it . . . and less of other now more expensive products. • Income effect: as the price of a product falls, consumers’ real income rises and this induces them to buy more of the product.

  11. Time Cost and Consumer Choice • The monetary price of a good is not always a complete measure of its cost to the consumer. • Consumption of most goods requires time as well as money. Like money, time is scarce to the consumer. • So a lower time cost, like a lower money price, will make a product more attractive. • Time costs, unlike money prices, differ among individuals

  12. 2. Market Demand Reflects the Demand of Individual Consumers

  13. Jones Smith Two-person market Price Price Price D d d Weekly frozen pizza consumption Individual and Market Demand Curves • Consider Jones’s demand for frozen pizza. At $3.50 Jones demands 1 pizza . . . at $2.50 Jones demands 3 pizzas . . . and so on . . . • Consider Smith’s demand for frozen pizza. At $3.50 Smith demands 2 pizzas . . . at $2.50 Smith demands 3 pizzas . . . and so on . . . • The market demand curve is merely the horizontal sum of the individual demand curves (here Jones and Smith). • The market demand curve will slope downward to the right, just as the individual demand curves do. $3.50 $3.50 $3.50 $2.50 $2.50 $2.50 1 3 2 3 3 6

  14. Total Versus Marginal Value • A good with high total value can have low marginal value, and vice versa. • Because market price is a marginal valuation, it does not have to correlate with the total value of the good. • An Example: • The diamond - water paradox. • Even though the total value of water is great, its marginal value is low because of its abundant supply. • In contrast, the marginal value of diamonds is high because of their scarcity.

  15. 3. Determinants of Specific Preferences: Why Consumers Buy What They Buy

  16. Consumer Preferences • The determining factors in consumer preferences are frequently complex. • Consumer preferences are shaped by attitudes toward time and risk. • Advertising influences consumer choice and preferences.

  17. Advertising • The advertising budgets of profit-seeking business firms indicate that it influences the choices of consumers. • Advertising can: • reduce the search time of consumers • help them make more informed choices • provide assurances with regard to quality (through brand names).

  18. 1. What’s wrong with this way of thinking?“Economics is unable to explain the value of goods in a sensible manner. A quart of water is much cheaper than a quart of oil. Yet water is essential to both animal and plant life. Without it, we could not survive. How can oil be more valuable than water? Yet economics says that it is.” Questions for Thought: 2. “Market competition encourages deceitful advertising and dishonesty.” Is this statement true or false? Explain your answer.

  19. 4. Elasticity of Demand

  20. % Change in quantity demanded % Q Price Elasticityof demand % P % Change in Price Elasticity of Demand • Price elasticity reveals the responsiveness of the amount purchased to a change in price. = = - or put simply -

  21. Price Price Price Mythicaldemandcurve • Perfectly inelastic: Despite an increase in price, consumers still purchase the same amount. In fact, the substitution and income effects prevent this from happening in the real world. Quantity/time Quantity/time Quantity/time Demandfor Cigarettes (a) • Relatively inelastic: A percent increase in price results in a smaller % reduction in sales. The demand for cigarettes has been estimated to be highly inelastic. (b) Demand curve of unitary elasticity • Unitary elasticity: The % change in quantity demanded is equal to the % change in price. A curve of decreasing slope results. Sales revenue (price times quantity sold) is constant. (c) Elasticity of Demand

  22. Price Price • Relatively elastic: A percent increase in price leads to a larger % reduction in purchases. When good substitutes are available for a product (as is the case for apples), the amount purchased will be highly sensitive to a change in price. Quantity/time Quantity/time (d) Demandfor Apples • Perfectly elastic: Consumers will buy all of Farmer Jones’s wheat at the market price, but none will be sold above the market price. Demand for Farmer Jones’s wheat (e) Elasticity of Demand

  23. Recall - = Elasticity (– ) 0.14 ( - ) 0.14 = D Elasticity of Demand (110 - 100) (110 + 100) Price($) ($1 - $2) ($1 + $2) • With this straight-line (constant-slope) demand curve, demand varies across a range of prices. • Using the equation for elasticity from before, the formula for arc elasticity shows that, when price rises from $1 to $2 . . . and quantity demanded falls from 110 to 100 . . . the elasticity for that region of the demand curve is ( - .14 ) (inelastic). 2 1 100 110 QuantityDemanded /Time

  24. Recall - = Elasticity (– ) 7.0 ( - ) 7.0 = D Elasticity of Demand (20 - 10) (20 + 10) Price($) ($10 - $11) ($10 + $11) • A price increase of the same magnitude (but a smaller %) from $10 to $11 . . . 11 leads to a decline in quantity demanded from 20 to 10. Even though the change in price here was smaller than before (as a %) the same change in quantity demanded occurred. 10 • Using the same equation to calculate elasticity as before, the elasticity amounts to - 7.0 (greater than - .14 from before). • Thus the price-elasticity of a straight-line demand curve increases as price rises. 10 20 QuantityDemanded /Time

  25. Determinants of Price Elasticity of Demand • When good substitutes for a product are available, a rise in price induces many consumers to switch to other products causing demand to be elastic. • Share of total budget expended on product • As the share of the total budget expended on the product rises, demand is more elastic. • Availability of substitutes

  26. Elastic and Inelastic Demand Price Price $1.50 $1.50 $1.00 $1.00 D D 25 100 90 100 (a) Ballpoint pens per week (in thousands) (b) Cigarette packs per week (in millions) • As the price of ballpoint pens (a) rises from $1.00 to $1.50 (a 50% increase in price). . . quantity demanded plunges from 100,000 to 25,000 (a 75% decrease in quantity demanded). • The % reduction in quantity demanded is larger than the % increase in price, thus the demandfor ballpoint pens is elastic. • As the price of cigarettes (b) rises from $1.00 to $1.50 (a 50% increase in price). . . quantity demanded plunges from 100 mil. to 90 mil. (a 10% decrease in quantity demanded). • The % reduction in quantity demanded is smaller than the % increase in price, thus the demandfor cigarettes is inelastic.

  27. Time and Demand Elasticity • If the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run. • Thus, the demand for most products will be more elastic in the long run than in the short run. • This relationship is often referred to as the second law of demand.

  28. Elasticity of Demand APPROXIMATELY UNITARY ELASTICITY INELASTIC Movies 0.9 Salt 0.1 Housing, owner occupied (long run) 1.2 Matches 0.1 Shellfish (consumed at home) 0.9 Oysters (consumed at home) 1.1 Toothpicks 0.1 Private education 1.1 Airline travel (short run) 0.1 Tires (short run 0.9 Gasoline (short run) 0.2 Tires (long run) 1.2 Gasoline (long run) 0.7 Radio and television receivers 1.2 Residential natural gas (short run) 0.1 Residential natural gas (long run) 0.5 Coffee 0.25 Fish (cod), consumed at home 0.5 ELASTIC Tobacco products (short run) 0.45 Restaurant meals 2.3 Legal services (short run) 0.4 Foreign travel (long run) 4.0 Physician services 0.6 Airline travel (long run) 2.4 Taxi (short run) 0.6 Fresh green peas 2.8 Automobiles (long run) 0.2 Automobiles (short run 1.2–1.5 Chevrolet automobiles 4.0 Fresh tomatoes 4.6 • Can you explain why the demand for some goods is highly inelastic while that for others is elastic.

  29. 5. Total Revenue, Total Expenditure, and the Price Elasticity of Demand

  30. -- unchanged -- unchanged -- -- Total Expenditures and Demand Elasticity Impact of Lowering Priceon Total ConsumerExpenditures or a Firm’sTotal Revenue Impact of Raising Price on Total Consumer Expenditures or a Firm’sTotal Revenue NumericalElasticityCoefficient(In Absolute Value) Price ElasticityOf Demand  1 to Elastic decrease increase Unitary Elastic 1 Inelastic 0 to 1 increase decrease • The table above summarizes the relationship between changes in price and total expenditures for demand curves of varying elasticity.

  31. (b) The Firm’s Demand Curve, Total Revenue, and Elasticity Price Price Elasticity Here demand is elastic so lower prices result in more e = 17.00 revenue and higher prices $9 e = 5.00 result in less revenue $8 e = 2.60 Total revenue unchanged $7 by price when demand is e = 1.57 $6 unitary elastic e = 1.00 $5 Here demand is inelastic e = 0.64 $4 so lower prices result in e = 0.38 less revenue and higher $3 prices result in more e = 0.20 $2 revenue e = 0.06 $1 (a) The Firm’s Price, Quantity Sold, Total Revenue, and Price Elasticity $0 Quantity 0 1 2 3 4 5 6 7 8 9 Quantity Total Price Sold Revenue Price Elasticity of Demand x = $9 0 $0 x = $8 1 $8 x = $7 2 $14 x = $6 3 $18 x = $5 4 $20 x = $4 5 $20 x = $3 6 $18 x = $2 7 $14 x = $1 8 $8 x = $0 9 $0 Total Revenues and Demand Elasticity P XQ = TR $9 x 0 = $0 $8 x 1 = $8 $7 x 2 = $14 $6 x 3 = $18 $5 x 4 = $20 $4 x 5 = $20 $3 x 6 = $18 $2 x 7 = $14 $1 x 8 = $8 $0 x 9 = $0 ((0-1) / (0+1)) / ((9-8) / (9+8)) = 17.00 • By tracing out the demand curve, one can follow how changes in price (through changes in quantity demanded) change total revenue collected. ((1-2) / (1+2)) / ((8-7) / (8+7)) = 5.00 ((2-3) / (2+3)) / ((7-6) / (7+6)) = 2.60 ((3-4) / (3+4)) / ((6-5) / (6+5)) = 1.57 ((4-5) / (4+5)) / ((5-4) / (5+4)) = 1.00 • By calculating the price elasticity of demand at different points along the demand curve, one can follow how and where total revenue is maximized. ((5-6) / (5+6)) / ((4-3) / (4+3)) = 0.64 ((6-7) / (6+7)) / ((3-2) / (3+2)) = 0.38 ((7-8) / (7+8)) / ((2-1) / (2+1)) = 0.20 ((8-9) / (8+9)) / ((1-0) / (1+0)) = 0.06

  32. Total Revenue ismaximized somewherebetween $4 and $5 (where demand isunitary elastic). Total Revenue ismaximized somewherebetween 4 and 5 units (again, where demand is unitary elastic). Price Total Revenue $9 $20 $8 $7 $15 $6 $5 $10 $4 $3 $5 $2 $1 $0 $0 0 1 2 3 4 5 6 7 8 9 $0 $5 $10 $15 $20 Quantity Total Revenue (d) Quantity versus Total Revenue (c) Price versus Total Revenue Total Revenues and Demand Elasticity • The firm maximizes its revenue at the price (or quantity) where demand is unitary elastic. (a) The Firm’s Price, Quantity Sold, & Total Revenue Quantity Total Elasticity Price Sold Revenue x = $9 0 $0 17.00 x = $8 1 $8 5.00 x = $7 2 $14 2.60 x = $6 3 $18 1.57 x = $5 4 $20 1.00 x = $4 5 $20 .64 x = $3 6 $18 .38 x = $2 7 $14 .20 x = $1 8 $8 .06 x = $0 9 $0

  33. 6. Income Elasticity

  34. Income Elasticityof demand % Change in quantity demanded % Change in Income Income Elasticity • Income elasticityindicates the responsiveness of the demand for a product to a change in income. =

  35. Income Elasticity • A normal good is any good with a positive income elasticity of demand. • As income expands, the demand for normal goods will rise. • Goods with a negative income elasticity are inferior goods. • As income expands, the demand for inferior goods will decline.

  36. 6. The Price Elasticity of Supply

  37. Price Elasticity of Supply • The price elasticity of supplyis the percent change in quantity supplied divided by the percent change in the price causing the supply response. • It is analogous to the price elasticity of demand. • However, the price elasticity of supply will be positive because the quantity producers are willing to supply is directly related price.

  38. 1. (a) Studies indicate that the demand for Florida oranges, Bayer aspirin, watermelons, and airfares to Europe are elastic. Why? Questions for Thought: (b) Why is the demand for salt, matches, and gasoline (short-run) inelastic? 2. Are the following statements true or false? Explain your answers. (a) A 10% reduction in price that leads to a 15% increase in amount purchased indicates a price elasticity of more than 1. (b) A 10% reduction in price that leads to a 2% increase in total expenditures indicates a price elasticity of more than 1.

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