Chapter 5

Demand and the Theory of

Consumer Behavior

Investigation of the Black Box behind

Downward Sloping Demand Curves
In this chapter,
• We will see how consumers allocate their
limited incomes across goods…limited incomes but
unlimited needs. Question becomes: how much to buy from
each good?
• and explain how these allocation decisions
determine the demand for various goods.
• We will also see how these decisions are
affected by changing prices and income.
• In understanding consumer behavior, our main
assumption is that people choose the goods and
services they value most highly.
• What we call in economics…utility.
• So, what do we mean by “utility”?
• In a word, utility denotes satisfaction.
• In the theory of demand, we assume that people
are rational,
– i.e. they maximize their utility; max (U)
• which means that they choose the bundle of
consumption goods, (x1, x2, x3,…), that gives
them maximum satisfaction.
 Total Utility, Marginal Utility
and
The Law of Diminishing Marginal Utility
• Example: Let’s say that drinking the first cup of water
gives you a certain level of utility/satisfaction.
• Now imagine drinking a second cup. Your total utility
goes up because the second cup of water gives you
some additional/extra utility.
• What about drinking a third and fourth cup?
• Eventually, if you keep drinking water, instead of adding
to your satisfaction or utility, it makes you sick!
• This leads us to the fundamental economic concept of
marginal utility…utility of each extra unit
• Definition: MU is the additional utility you get
from consuming an additional/extra unit of
the good.
• One of the fundamental ideas behind the
theory of demand is the law of diminishing
marginal utility.
– This law states that the amount of marginal utility
declines as a person consumes more and more of
a good.
From the previous graph:
• The law of diminishing marginal utility implies
that the marginal utility ( MU ) curve must
slope downward.
• This is exactly equivalent to saying that the
total utility curve must look concave, like a
dome.
– Concave means increasing with decreasing rate.
• Note that: The total utility of consuming a
certain amount is equal to the sum of the
marginal utilities up to that point.
 DEMAND CURVES
• Having explained utility, we will now apply it
to understand the nature of demand curves.
Assumptions:
• Each consumer maximizes utility…rational
• Consumers have a certain level of income
• They face given market prices for goods.
What would be a sensible rule for choosing the
utility-maximizing consumption bundle of
goods (or consumer equilibrium)?
Equimarginal Principle
Why must this condition hold?
• Case I: If any one good gave more marginal utility per
pound, I would increase my utility by taking money away
from other goods and spending more on that good—until
the law of diminishing marginal utility drives its marginal
utility per pound down to equality with that of other goods.
• Case II: If any good gave less marginal utility per pound
than the common level, I would buy less of it until the
marginal utility of the last pound spent on it had risen back
to the common level.
• The common marginal utility per pound of all commodities,
in consumer equilibrium, is called the marginal utility of
income.
– It measures the additional utility that would be gained if the
consumer could enjoy an extra pound’s worth of consumption.
 Why Demand Curves Slope Downward
• Holding the common marginal utility of income
constant.
• Then increasing the price of good 1.
• With no change in quantity consumed, the first ratio
will be below the MU per pound of all other goods. The
consumer will therefore have to readjust the
consumption of good 1 by:
– lowering the consumption of good 1,
– thereby raising the MU of good 1,
– until the new marginal utility per pound spent on good 1 is
again equal to the MU per pound spent on other goods.
• Conclusion: A higher price for a good reduces the
consumer’s consumption of that commodity; a reason
why demand curves slope downward.
SUBSTITUTION EFFECT AND INCOME EFFECT:
AN ALTERNATIVE APPROACH to understanding
downward sloping demand curves:
1. Substitution Effect
• It is the most obvious factor for explaining
downward-sloping demand curves.
• It says that when the price of a good rises,
consumers will tend to substitute other goods for
the more expensive good.
– If the price of coffee goes up, while other prices do
not, then coffee has become relatively more
expensive. Thus, less coffee and more tea will be
consumed, i.e, demand for coffee will fall.
2. Income Effect
• A second impact of a price change comes
through its effect on real income, where real
income means the actual quantity of goods
that your income can buy.
• When a price rises while money income is
fixed, real income falls because the consumer
cannot afford to buy the same quantity of
goods as before.