Consumer Demand Theory

Prof. John M. Abowd

Themes of Today's Lecture

• The Two Components of Consumer Demand
• Budget Constraint
• Utility and Preferences
• Introduction to Indifference Curves
• Simple Derivation of a Demand Curve

What is Consumer Demand?

• Study of how people use their limited means to make purposeful choices.
• Assumes that consumers understand their choices (possibilities) and the prices (opportunity costs) associated with each choice.
• Assumes that consumers consider the alternatives and choose the one that they like best.

Are Consumers Predictable?

• You don't buy the same things every time you go to the grocery store even though the prices and your income haven't changed.
• Does this mean you are unpredictable?
• No. Demand theory predicts your purchases over a period of time facing the same prices and income.

Two Components of Consumer Demand

• Opportunities:
  • What can the consumer afford?
  • What are the consumption possibilities?
  • Summarized by the budget constraint
• Preferences:
  • What does the consumer like?
  • How much does a consumer like a good?
  • Summarized by the utility function

Why Don't We Just Use the Demand Curve by Itself?

• A particular demand curve for a single good summarizes a consumer's intended purchases at each price, holding constant other prices and income.
• Demand theory allows us to quantify the changes in consumer purchases of all goods when prices or income change. It shows us the relationships among all of the consumer's demand curves: food, clothing, energy, transportation, recreation, etc.

What is a Budget Constraint?

• A budget constraint shows the consumer's purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.
• The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.

Demand for Wheat and Rice

• Illustration of demand theory
• Li's demand for wheat and rice depends upon the prices for these goods, her income, and her preferences.
• Wheat costs $4/lb.
• Rice costs $2/lb.
• Li has $40 of income.

Li's Budget Constraint Li faces the prices: wheat $4/lb. and rice $2/lb. Li・s income is $40. The table shows the combinations of wheat and rice that Li can buy with her income.

Li's Budget Constraint

• The mathematical expression for Li's budget constraint is: Income = Price Wheat x Wheat + Price Rice x Rice
• In symbols: I = P_W W + P_R R

Points on Li's Budget Constraint

• So, all the points on Li's budget constraint satisfy the equation: 40 = 4 Wheat + 2 Rice
• Which can be re-written: Rice = (40 - 4 Wheat)/2
• Slope of the budget constraint is -P_W/P_R = -4/2 = -2

Graph of Li's Budget Constraint The graph below shows a picture of Li's budget constraint. Each diamond is a point from the table. Notice that the slope = -2 = -PW/PR

Li's Income Goes Up When Li・s income goes up to $80, she is able to buy more rice and more wheat. The purple squares show her new budget constraint. Notice that the slope doesn・t change.

Li Faces New Prices Now, suppose that the price of wheat falls to $2/lb. and the price of rice is still $2/lb. The purple squares show the new budget constraint. Notice that the slope is now -2/2 = -1

Utility and Preferences

• Utility is the way economists measure preferences.
• Among two choices, the one with the higher utility is the preferred choice.
• If two choices have the same utility, we say that the consumer is indifferent.

Li's Marginal Utility of Wheat The figure at the right shows Li・s marginal utility of wheat, holding her consumption of rice constant. Declining marginal utility is one of the economists general descriptions of behavior. As Li increases her consumption of wheat, holding rice consumption constant, her additional utility from each extra unit of wheat delcines. Her total utility is going up, but by less and less for each additional unit of wheat.

Li's Marginal Utility of Rice The graph below shows Li's marginal utility of rice consumption holding wheat consumption constant. Li's marginal utility from additional units of rice is also delcining, again holding wheat consumption constant.

Indifference Curves

• Preferences that satisfy the conditions I have noted above--decreasing marginal utility as one good is increased, holding the quantity of the other good constant--can be represented by indifference curves.
• An indifference curve connects all of the points that a consumer likes equally.

Li's Preferences in Indifference Curves The indifference curves measure Li・s preferences. Points on I2 are preferred to points on I1. Points on I1 are preferred to points on I0.

Li・s Budget Constraint at Three Different Wheat Prices The three budget lines illustrated on this slide correspond to 3 different wheat prices PX =  4 (green, +) PX  = 2 (red, x) PX  = 1 (blue, o)

How Much Wheat and Rice?

• The optimal amount of wheat and rice to consume is the amount that maximizes utility.
• Utility is at a maximum when increasing wheat by one unit, and correspondingly decreasing rice by one unit, leaves the consumer just as well off as the reverse operation (wheat down one unit, rice up one unit).
• Only combinations that are on the budget constraint need be considered.

How to Find the Utility Maximum

• Utility is at a maximum when the ratio of the marginal utilities of the two goods is equal to the ratio of their prices.
• The equation is MU_W/MU_R = P_W/P_R

Li's Demand for Wheat The best choice is the point of tangency between the budget line and the indifference curves. A, B, and C mark the best choices.

Li's Demand for Wheat The table shows the amount of wheat that Li demands at each price. These are the points of tangency from the previous slide.

Graph of Li's Demand for Wheat When we connect the points from the table in the previous slide we get Li・s demand for wheat.

Review of Today's Lecture

• We study demand theory to understand what lies behind the choices consumers make on their demand curves.
• Budget constraints tell us what is possible.
• Utility tells us what is preferable.
• The theory of consumer demand says that utility is maximized given the budget constraint.

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Last modified: May 11, 1999 10:06 PM (lecture-demand.html)

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