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Background to Demand

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  1. Backgroundto Demand

  2. Background to Demand Marginal Utility Theory

  3. Marginal utility theory • Total and marginal utility • meaning of total utility • marginal utility: TU/Q • diminishing marginal utility • total and marginal utility curves

  4. Ollie's utility from consuming crisps (daily) Packets of crisps TU in utils 0 1 2 3 4 5 6 0 7 11 13 14 14 13 Utility (utils) Packets of crisps consumed (per day)

  5. Ollie's utility from consuming crisps (daily) TU Packets of crisps TU in utils 0 1 2 3 4 5 6 0 7 11 13 14 14 13 Utility (utils) Packets of crisps consumed (per day)

  6. Ollie's utility from consuming crisps (daily) TU MU in utils Packets of crisps TU in utils - 7 4 2 1 0 -1 0 1 2 3 4 5 6 0 7 11 13 14 14 13 Utility (utils) Packets of crisps consumed (per day)

  7. Ollie's utility from consuming crisps (daily) TU MU in utils Packets of crisps TU in utils - 7 4 2 1 0 -1 0 1 2 3 4 5 6 0 7 11 13 14 14 13 Utility (utils) MU Packets of crisps consumed (per day)

  8. Ollie's utility from consuming crisps (daily) DTU = 2 DQ = 1 MU = DTU / DQ TU Utility (utils) MU Packets of crisps consumed (per day)

  9. Ollie's utility from consuming crisps (daily) TU DTU = 2 DQ = 1 Utility (utils) MU = DTU / DQ = 2/1 = 2 MU Packets of crisps consumed (per day)

  10. Marginal utility theory • The optimum level of consumption: the one-commodity version • consumer surplus (total and marginal) • marginal consumer surplus: MU – P • total consumer surplus: TU – TE

  11. Consumer surplus Total consumer surplus P1 Total consumer expenditure MU Q1 MU, P O Q

  12. Marginal utility theory • The optimum level of consumption: the one-commodity version • consumer surplus (total and marginal) • marginal consumer surplus: MU – P • total consumer surplus: TU – TE • maximising consumer surplus: P = MU • Marginal utility and the demand curve

  13. Deriving an individual person’s demand curve Consumption at Q1 where P1 = MU a P1 Q1 MU, P MU = D O Q

  14. Deriving an individual person’s demand curve Consumption at Q2 where P2 = MU b P2 Q2 MU, P a P1 MU = D O Q1 Q

  15. Deriving an individual person’s demand curve Consumption at Q3 where P3 = MU c P3 Q3 MU, P a P1 b P2 MU = D O Q1 Q2 Q

  16. Marginal utility theory • Limitations of the one-commodity version • marginal utility affected by consumption of other goods • marginal utility of money not constant • Optimum combination of goods • the equi-marginal principle • MUA/MUB = PA/PB • deriving a demand curve

  17. Background to Demand Risk, Uncertainty and Insurance

  18. Risk, uncertainty and insurance • Demand under conditions of risk and uncertainty • defining risk and uncertainty • types of odds • risk attitudes • Diminishing marginal utility of income and attitudes towards risk taking

  19. Total utility of income TU c U3 b U2 a U1 Diminishing marginal utility of income Total utility 0 10 000 15 000 5000 Income (£)

  20. Total utility of income d U4 = ½ (U1 + U3) TU c U3 b U2 U4 a U1 Total utility £10 000 is preferable to a 50:50 chance of either £5000 or £15 000 0 10 000 15 000 5000 8000 Income (£)

  21. Risk, uncertainty and insurance • Insurance: a way of removing risks • How insurers spread risks • the law of large numbers • importance of the independence of risks • Problems for insurers • adverse selection • moral hazard • Solutions to moral hazard and adverse selection

  22. Background to Demand Indifference Analysis

  23. Indifference analysis • Indifference curves • constructing an indifference curve

  24. Constructing an indifference curve Pears Point Oranges a b c d e f g 30 24 20 14 10 8 6 6 7 8 10 13 15 20 Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges

  25. Constructing an indifference curve Pears Point Oranges a b c d e f g 30 24 20 14 10 8 6 6 7 8 10 13 15 20 Pears Oranges

  26. Constructing an indifference curve a Pears Point Oranges a b c d e f g 30 24 20 14 10 8 6 6 7 8 10 13 15 20 Pears Oranges

  27. Constructing an indifference curve a Pears Point Oranges b a b c d e f g 30 24 20 14 10 8 6 6 7 8 10 13 15 20 Pears Oranges

  28. Constructing an indifference curve a Pears Point Oranges b a b c d e f g 30 24 20 14 10 8 6 6 7 8 10 13 15 20 c Pears d e f g Oranges

  29. Indifference analysis • Indifference curves • constructing an indifference curve • the shape of an indifference curve • diminishing marginal rate of substitution

  30. Deriving the marginal rate of substitution (MRS) a b 26 DX = 1 6 7 MRS = 4 DY = 4 MRS = Y/X Units of good Y Units of good X

  31. Deriving the marginal rate of substitution (MRS) c 9 DX = 1 13 14 a MRS = 4 DY = 4 b 26 MRS = Y/X DX = 1 Diminishing marginal rate of substitution Units of good Y MRS = 1 d DY = 1 6 7 Units of good X

  32. Indifference analysis • Indifference curves • constructing an indifference curve • the shape of an indifference curve • diminishing marginal rate of substitution • an indifference map

  33. An indifference map I5 I4 I3 I2 I1 The further out the curve, the higher the level of utility Units of good Y An indifference curve shows all combinations of X and Y that give a particular level of utility. Units of good X

  34. a c I2 b The impossibility of two indifference curves crossing A consumer cannot be indifferent between a and bothb and c Units of good Y I1 Units of good X

  35. Indifference analysis • Indifference curves • constructing an indifference curve • the shape of an indifference curve • diminishing marginal rate of substitution • an indifference map • The budget line • constructing a budget line

  36. A budget line Units of good X 0 5 10 15 Units of good Y 30 20 10 0 Assumptions PX = £2 PY = £1 Budget = £30

  37. A budget line Point on budget line a a Units of good X 0 5 10 15 Units of good Y 30 20 10 0 Units of good Y Assumptions PX = £2 PY = £1 Budget = £30 Units of good X

  38. A budget line a Point on budget line a b Units of good X 0 5 10 15 Units of good Y 30 20 10 0 b Units of good Y Assumptions PX = £2 PY = £1 Budget = £30 Units of good X

  39. A budget line a Point on budget line a b c Units of good X 0 5 10 15 Units of good Y 30 20 10 0 b Units of good Y c Assumptions PX = £2 PY = £1 Budget = £30 Units of good X

  40. A budget line a Point on budget line a b c d Units of good X 0 5 10 15 Units of good Y 30 20 10 0 b Units of good Y c Assumptions PX = £2 PY = £1 Budget = £30 d Units of good X

  41. Indifference analysis • Indifference curves • constructing an indifference curve • the shape of an indifference curve • diminishing marginal rate of substitution • an indifference map • The budget line • constructing a budget line • effect of a change in income

  42. Effect of an increase in income on the budget line Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y Units of good X

  43. Effect of an increase in income on the budget line Assumptions PX = £2 PY = £1 Budget = £40 n m 16 7 Units of good Y Budget = £40 Budget = £30 Units of good X

  44. Indifference analysis • Indifference curves • constructing an indifference curve • the shape of an indifference curve • diminishing marginal rate of substitution • an indifference map • The budget line • constructing a budget line • effect of a change in income • effect of a change in price

  45. Effect on the budget line of a fall in the price of good X Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y Units of good X

  46. Effect on the budget line of a fall in the price of good X Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y Units of good X

  47. Effect on the budget line of a fall in the price of good X Assumptions PX = £1 PY = £1 Budget = £30 Units of good Y Units of good X

  48. Effect on the budget line of a fall in the price of good X a Assumptions PX = £1 PY = £1 Budget = £30 Units of good Y B2 B1 c b Units of good X

  49. Indifference analysis • The optimum consumption point

  50. Finding the optimum consumption Units of good Y O Units of good X