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HKALE Microeconomics

HKALE Microeconomics. Chapter 3: Consumer Demand(1)-The MUV Approach and Exchange. Six Basic Postulates. Each individual desires more goods and has many goals. For each individual, some goods are scare.

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HKALE Microeconomics

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  1. HKALE Microeconomics • Chapter 3: Consumer Demand(1)-The MUV Approach and Exchange CH3-Consumer's Demand(1)

  2. Six Basic Postulates • Each individual desires more goods and has many goals. • For each individual, some goods are scare. • Postulate of substitution: economic goods are substitutable, i.e. each person is willing to forsake some of a good to get more of other goods. CH3-Consumer's Demand(1)

  3. Six Basic Postulates 4. Postulate of diminishing MUV: the more of a good one has, the larger the TUV, but the lower the MUV of a unit. 5. Not all individuals have identical tastes and preferences. 6. Individuals are innovative but logically consistent in making choice. CH3-Consumer's Demand(1)

  4. Use Value and Exchange Value • Value can be referred to use value or exchange/market value. • (Personal) use value (or value in use) of a unit of a good is defined as the maximum amount of another good which a person is willing to forgo in order to obtain it. • Exchange value (or value in exchange) is defined as the amount of some other goods or money that a consumer has to pay for a given amount of a good in the market. CH3-Consumer's Demand(1)

  5. Use Value Vs. Exchange Value • The use value of a good is the maximum amount of other good one is willing to give up for obtaining that good. • The exchange value of a good is, however, the amount of other good to be exchanged within a transaction. CH3-Consumer's Demand(1)

  6. Use Value Vs. Exchange Value • Use value is subjective. • However, exchange value is an objective concept because it can be measured, e.g. an apple can be exchanged with two lemons in a transaction. CH3-Consumer's Demand(1)

  7. Use Value Vs. Exchange Value • The use value of a good depends on how people evaluate the good(i.e. individual preference) or is positively related to the number of its uses. • However, the exchange value of a good depends on the demand for and the supply of the good, i.e. depending on the degree of scarcity. CH3-Consumer's Demand(1)

  8. Use Value Vs. Exchange Value • The use value of a good may be measured by the amount of money one is willing to sacrifice. • The exchange value of a good, however, if measured in terms of money, is called money price; if measured in terms of other good, it is called relative price. CH3-Consumer's Demand(1)

  9. Use Value Vs. Exchange Value • Paradox of value: the use value of a good may not be in proportion to its exchange rate. • Example: water has high use value but low exchange value, while diamond has low use value but high exchange value. CH3-Consumer's Demand(1)

  10. Value Vs. Cost: Differences • Value is the max. amount of other good one is willing to forgo for obtaining a good. • Cost is the value of the highest-valued option forgone in making a decision. CH3-Consumer's Demand(1)

  11. Value Vs. Cost: Differences • Value is a reflection of an individual's preference. • Cost, however, as an ex-ante concept, is a constraint of behavior. CH3-Consumer's Demand(1)

  12. Value Vs. Cost: Differences • The value of a free good may be positive while the cost of a free good, however, is zero. • Value arises when people make personal valuation while cost arises because of scarcity. CH3-Consumer's Demand(1)

  13. Value Vs. Cost: Similarities • They are measured in terms of other goods. • They are expressed in terms of 'maximum' amount of other good. • They can affect decision-making. CH3-Consumer's Demand(1)

  14. Value Vs. Cost • Cost and value are not necessarily related. In fact, cost and value are used to derive the decision-making process of individuals. • Example: a hair cut poorer than anticipated only reduces its value, but it does not raise its cost. The cost of the hair cut will rise if the time involved in getting it done, increases in value. CH3-Consumer's Demand(1)

  15. Cost Vs. Price • Cost is the highest-valued option forgone while price is the physical exchange rate of one good for another good. • Cost arises because of scarcity, no choice hence results in no cost. However, price arises because of exchange, no exchange hence leads to no price. CH3-Consumer's Demand(1)

  16. Cost Vs. Price • Cost still exists in an one-man economy while price is absent in one-man economy because of no interpersonal exchange. CH3-Consumer's Demand(1)

  17. TUV, AUV & MUV • Total use value (TUV) is the maximum total amount of another good that one is willing to pay for the entire quantity of a good. • Average use value (AUV) is the total use value divided by the number of units (Q) of a good, i.e. TUV/Q • Marginal use value (MUV) is the maximum amount of another good that a person is willing to pay for an extra unit of a good. MUV=TUV/Q=slope of TUV curve. CH3-Consumer's Demand(1)

  18. TUV, AUV & MUV: Illustration CH3-Consumer's Demand(1)

  19. Use Value TUV AUV MUV 0 Q TUV, AUV & MUV: Diagrams CH3-Consumer's Demand(1)

  20. The Marginal Use Value Curve • A MUV curve slopes downward indicating that as one's holdings of a good get larger, there is a decrease in one's marginal personal value for that good. • The position or height of the whole curve varies positively with the wealth (or number of other goods) a person has: it shifts upward for superior goods and downward for inferior goods. • With different tastes or preferences, the MUV curves are not identical for everyone. CH3-Consumer's Demand(1)

  21. Price, MUV & Consumer's Equilibrium • In making consumption, individuals will compare its cost (P) with expected benefits (MUV) of a good. • If MUV>P, it is beneficial to buy and thus bringing down MUV until decreasing MUV=P. • If, however, MUV<P, one will reduce his quantity demanded for avoiding loss, which brings up MUV until increasing MUV=P. • Hence, consumer's equilibrium is attained when P=MUV (for the last/marginal unit transacted). CH3-Consumer's Demand(1)

  22. Demand Curve and MUV Curve • A consumer's MUV curve of a good can be regarded as an ordinary individual demand curve for that good because: • given the MUV curve, one maximizes his gain by equating his MUV with the market price. • it tells how many units one consumes given any level of market prices. CH3-Consumer's Demand(1)

  23. Price, Total Revenue, Average Revenue & Marginal Revenue • Total revenue, TR=PXQ • Average revenue • AR=TR/Q • Then, AR=(PXQ)/Q • Thus, AR=P • Marginal revenue, MR=TR/Q CH3-Consumer's Demand(1)

  24. Demand Curve & Average Revenue (AR) Curve • Demand curve reflects relationship between P & Qd while AR curve reflects AR & Qd(=Qs=Qt at equilibrium). • As P=MUV and P=AR,  P=AR=MUV • Hence, AR curve=D curve=MUV curve CH3-Consumer's Demand(1)

  25. P, TR, AR & MR: Illustration CH3-Consumer's Demand(1)

  26. TR TR 0 Q AR, MR AR MR 0 Q TR, AR & MR: Diagrams CH3-Consumer's Demand(1)

  27. TR reaches its maximum when MR=0. TR TR 0 Q AR, MR MR AR 0 Q TR, AR & MR: Diagrams CH3-Consumer's Demand(1)

  28. TR TR reaches its maximum when MR=0. TR 0 Q TR rises when MR is positive AR, MR MR AR 0 Q TR, AR & MR: Diagrams CH3-Consumer's Demand(1)

  29. TR 0 Q AR, MR 0 Q TR, AR & MR: Diagrams TR reaches its maximum when MR=0. TR falls when MR falls TR TR rises when MR rises MR AR CH3-Consumer's Demand(1)

  30. P AR P1 TR 0 Q1 Q Finding TR from AR Curve • TR=rectangular area defined by drawing perpendicular lines from a particular price and the corresponding quantity to the demand/AR curve. CH3-Consumer's Demand(1)

  31. P, AR, MR MR1 for 1st unit sold AR P1 0 1 2 3 4 Q MR Finding TR from MR Curve • TR=the area under the MR curve and above the quantity axis. CH3-Consumer's Demand(1)

  32. P, AR, MR Summation of MR for 4 units sold AR P1 TR 0 4 Q MR Finding TR from MR Curve • TR=the area under the MR curve and above the quantity axis. CH3-Consumer's Demand(1)

  33. Finding MR from TR Curve • MR=slope of the TR curve=TR/ Q. P, AR, MR, TR Slope of TR curve = MR TR1 E TR TR 0 Q1 Q Q CH3-Consumer's Demand(1)

  34. Finding AR from TR curve • AR=TR/Q=slope of a ray from the origin to a point on TR, say point E. P, AR,MR, TR A ray from the origin to point E TR1 E TR Slope of the ray = AR TR at point E 0 Q1 Q Q at point E CH3-Consumer's Demand(1)

  35. Why is Price Larger Than MR? • Because a cut in price is made to sell more units, the extra revenue will be less than the price received on the extra unit sold. • However, the new uniform price at which an extra unit is sold is lower on ALL the units formerly sold at the higher price. • Reduction in revenue on the quantity previously sold at the higher price will offset part of (or possibly more than) the price received on the extra unit sold. CH3-Consumer's Demand(1)

  36. Why is Price Larger Than MR? • Thus, the net revenue increase or MR from selling one more at the new, lower price will always be less than the price received on that extra unit – less by the amount of reduced revenue on all the units formerly salable at the old, higher price. • With different pricing tactics, say price discrimination, MR could be equal to P. • MR =P2(Q2-Q1)-(P1-P2)Q1 CH3-Consumer's Demand(1)

  37. P, AR, MR Loss in TR P1=$10 P2=$9 Gain in TR  MR from selling 2nd unit D=AR 0 Q1 Q2 Q 1 2 Relations Between TR, AR & MR • MR is less than AR(or P) CH3-Consumer's Demand(1)

  38. MR = P2(Q2-Q1) -(P1-P2)Q1 P, AR, MR Loss in TR Part of the TR from selling 2nd unit will be taken away as a compensation for loss in revenue of the previous unit(s) under uniform pricing. P1=$10 P2=$9 $8 D=AR 0 Q1 Q2 Q MR of 2nd unit sold Relations Between TR, AR & MR • MR is less than AR(or P) CH3-Consumer's Demand(1)

  39. Relations Between TR, AR & MR • MR is less than AR(or P): an illustration CH3-Consumer's Demand(1)

  40. P, AR, MR B A P1 C D=AR 0 Q1 MR Relations Between TR, AR & MR • The slope of MR curve is twice the slope of AR curve. Remarks: Point A=mid-point of AR curve Area BCP1=area ACQ1 CH3-Consumer's Demand(1)

  41. TEV, AEV & MEV • (Total)Exchange value (TEV) of a specified quantity of a good is the actual amount of money(or some other goods) that one has to pay for that entire specific quantity. • TEV=PXQ • TEV=Total revenue(TR)=Total expenditure(TE) =Total market value(TMV) CH3-Consumer's Demand(1)

  42. TEV, AEV & MEV • Average exchange value(AEV) of a specified quantity of a good is the average revenue received by the seller, i.e. AEV=AR=TEV/Q. • Marginal exchange value(MEV) is the actual amount of money or some other goods one pays for an extra unit of the good, i.e. MEV=TEV/Q. • Under uniform pricing/single per-unit pricing arrangement, price refers to AEV or AR. CH3-Consumer's Demand(1)

  43. Consumer's Surplus (CS) • CS is the extra amount the consumer is willing to pay over and above what he or she actually pays, given quantity demanded. • CS=TUV-TEV for a given quantity • CS=MUV-P for an extra unit • It is assumed that the CS is calculated under uniform pricing (or single per-unit pricing). CH3-Consumer's Demand(1)

  44. P, MUV • Remarks: • Area 0ABQ1=TUV • Area 0P1BQ1=TEV • CS=TUV-TEV • =area 0ABQ1-area 0P1BQ1 • =area ABP1 A CS B P1 TEV D=MUV 0 Q Q1 Consumer's Surplus (CS) CH3-Consumer's Demand(1)

  45. Consumer's Surplus (CS): An Illustration CH3-Consumer's Demand(1)

  46. Paradox of Value • Adam Smith pointed out in his book, 'The Wealth of Nations', that the things (e.g. water) which have the greatest value in use frequently have little or no value in exchange and those (e.g. diamond) which have the greatest value in exchange frequently have little value in use. CH3-Consumer's Demand(1)

  47. Resolving The Paradox of Value • The paradox arises from confusing total and marginal use values with market values. • The exchange value of a good is determined by its relative scarcity and its MUV, but not its TUV. • The more scarce the good, the higher its MUV will be, thus demanding a higher price(or average exchange value); vice versa. • While a good with higher TUV would bring a larger consumer's surplus and thus more benefit. CH3-Consumer's Demand(1)

  48. Diamond Water P, MUV P, MUV S S CS P TEV CS P TEV D=MUV D=MUV Q Q 0 0 Q Q Resolving The Paradox of Value CH3-Consumer's Demand(1)

  49. Ways to Extract Consumer's Surplus(1) • By all-or-nothing pricing tactic • Consumers either purchase a good at a stipulated quantity at a given price, or not at all. • The price under an all-or-nothing arrangement is set in accordance with the AUV of the last unit, i.e. P=AUV. • As the TUV of the good becomes the same as its TEV, CS is then fully exploited. CH3-Consumer's Demand(1)

  50. P, MUV, AUV Remarks: TEV=P2XQ2=area 0P2BQ2 TUV=area 0AEQ2 A C B P2=AUV All-or-nothing D=AUV P1=MUV E Ordinary D=MUV Q 0 Q1 Q2 Ways to Extract Consumer's Surplus(1) • By all-or-nothing pricing (AONP) tactic CH3-Consumer's Demand(1)

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