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Demand
Demand
PGDM RM 2010-12
OVERVIEW
Utility Theory
Indifference Curves
Budget Constraints
Individual Demand
Optimal Consumption
Demand Sensitivity Analysis: Elasticity
Price Elasticity of Demand
Cross-price Elasticity of Demand
Income Elasticity of Demand
KEY CONCEPTS
utility perfect complements
nonsatiation principle budget constraint
indifference income effect
ordinal utility substitution effect
cardinal utility price-consumption curve
utility function income-consumption curve
utils Engle curve
market baskets normal goods
marginal utility inferior goods
law of diminishing marginal Marginal rate of substitution
utility
indifference curves
substitutes
complements
perfect substitutes
Utility Theory
Assumptions About Consumer Preferences
More is better.
Consumers rank-order desirability of products.
Utility functions relate well-being to consumption.
Marginal utility shows added benefit of a small
increase in consumption.
Marginal utility is usually positive, MU>0.
Law of Diminishing Marginal Utility
Marginal utility eventually declines for everything.
Indifference Curves
Basic Characteristics
Higher indifference curves are better.
Indifference curves do not intersect.
Indifference curves slope downward.
Indifference curves are convex to origin.
Perfect substitutes are products that satisfy
the same need, e.g., car models.
Perfect complements are products consumed
together, e.g., cars and tires.
© 2009, 2006 South-Western, a
part of Cengage Learning
Budget Constraints
Basic Characteristics
Show affordable combinations of X and Y.
Slope of –PX/PY reflects relative prices.
Effects of Changing Income and Prices
Budget increase (decrease) causes parallel
outward (inward) shift.
Relative price change alters budget slope.
Income and Substitution Effects..
© 2009, 2006 South-Western, a
part of Cengage Learning
Price Consumption Curve
Price-consumption curve(PCC) shows
consumption impact of price changes.
PCC depicts various market baskets that
maximizes the utility
PCC explains how Optimal consumption of both
goods and services are affected by change in
Price of goods or services
Demand curve illustrates how quantity demanded
changes with a change in price
PCC Reflects movement along demand curve.
© 2009, 2006 South-Western, a
part of Cengage Learning
Income-consumption curve
shows consumption impact
of income changes.
Reflects shift from one
demand curve to another.
Engle curves plot income
and consumption.
Normal good consumption
rises with income.
Inferior good consumption
falls with income (rare).
©
Optimal Consumption
Marginal Rate of Substitution (MRS)
MRSXY = -MUX/MUY and equals indifference
curve slope.
MRSXY shows tradeoff between X and Y
consumption, holding utility constant.
MRSXY diminishes as substitution of X for Y
increases.
Utility maximization requires
PX/PY = MUX/MUY,.
Demand Sensitivity Analysis:
Elasticity
Elasticitymeasures sensitivity.
Point elasticity shows sensitivity of Y
to small changes in X.
εX = ∂Y/Y ÷ ∂X/X.
Arcelasticity shows sensitivity of Y to
big changes in X.
EX = (Y2–Y1)/(Y2+Y1) ÷ (X2-X1)/(X2+X1).
Price Elasticity of Demand
If Ep=0, demand is perfectly inelastic
If Ep=1,demand is unit elastic
If Ep=∞ demand is perfectly elastic
If 0<Ep>1, demand is inelastic
If 1<Ep> ∞, demand is elastic
Shape of demand curve- perfectly
elastic- Horizontal: perfectly inelastic
right angle
Price Elasticity - Determinants
Elasticity Varies along Demand Curve
As price rises, so too does │εP│.
As price falls, so too does│εP│.
(a)Availability of substitutes; (b)nature of
the goods( luxury or necessity); (c) Time
period(d) number of uses the
commodities is put to use
Close substitute- more elastic
Luxury- elastic
Necessity- inelastic
Demand is more elastic in the long run
More possible uses greater elastic