Eco

THEORY OF CONSUMER DEMAND

Presented By:

Archana Gawade - 1214AMS0Vishakha Kharat - 1214AMS0Jayesh Kambli - 1214AMS039

WHAT IS DEMAND? Its a want backed by willingness to pay

CONSUMER DEMAND THEORY:•The branch of economics devoted to the study of consumer

behavior

•Applies to decisions related to purchasing goods and services through markets.

•Largely centered on the study

•Analysis of the utility generated from the satisfaction of wants and needs.

•The key principle is the law of diminishing marginal utility

•Explanation for the law of demand and the negative slope of the demand curve.

DEMAND ANALYSISStudy of sales generated by a good or service to

determine thereasons for its success or failure, and how it

sales performance can be improved.

o Firms sell goods/services to buyers Consumers (individuals) : utility

Firms : make profits

o Willingness to pay: maximum price buyer will pay for a good Point of indifference between buying and not buying

Lower price always preferred by buyer

DEMAND ANALYSIS cont….. Willingness to pay is determined by

Buyer’s tastes or needs

Income and wealth

Normal/inferior goods

Cyclical/acyclical demand

Substitutes

Complementary goods

BASIC ASSUMPTIONS OF MARSHALLIAN UTILITY ANALYSIS

CARDINAL : Utility is measurable numerically.

INDEPENDENT: Utility of each commodity is experienced independently.

ADDITIVE : Goods can be measured by adding their independent utilities together.

CONSTANT :MU of money to be constant at all levels of income of the consumer.

RATIONALITY :consumer is rational maximization of tu he buys

LIMITATIONS OF THE MARSHALLIAN APPROACH

ADDITIVE UTILITY :utility cannot be measured quantitatively.

HOMOGENITY :utility or satisfaction derived from different goods is qualitatively homogenous.

CONSTANCY : MU of money remains constant.

INAPPLICABLITY :utility analysis is inapplicable for bulky goods. Eg.tv, fridge etc.

GIFFEN GOODS :there is paradox situation in which the consumer tends to buy less of such goods when their price falls.

THE PRINCIPLE OF DIMINISHING MARGINAL UTILITY

According to law of diminishing marginal utility a consumer tries to equalize marginal utility of a commodity with its price, so that his satisfaction is maximized.

Consumer is a rational and always tries to seek Maximum total utility when he buys goods.

• The law of diminishing marginal utility implies that by increasing the stock of commodity its marginal utility is diminished.

INDIFFERENCE CURVES A more advanced form of

consumer demand theory involves the analysis of indifference curves.

An indifference curve, such as the one labelled U in the exhibit to the right, presents all combinations of two goods that provide the same amount of utility.

Indifference curve analysis relies on a relative ranking of preferences between two goods rather than the absolute measurement of utility (utils) derived from the consumption of a particular good.

CONCEPT OF SCALE OF PREFERENCES ORDINAL UTILITY

Utility is viewed as the level of satisfaction rather than an amount of satisfaction.

The level of satisfaction is relatively comparable but not quantifiable.

CHARASTERSTICS OF SCALE OF PREFERENCES

Based on the subjective valuation

Differs from person to person

Significance of commodities

Drawn by a consumer mind

Independent of the price of the goods

PROPERTIES OF AN INDIFFERENCE CURVE

Generally, negatively sloped, reflecting marginal rate of substitution

Convex to the origin, reflecting diminishing marginal utility

Two indifference curves cannot cross

Special case: a positively sloped indifference curve

BUDGET LINE

Also know as Price Line, Consumption Possibility Line, Line of attainable combinations

A collection of commodity that are affordable forms the consumer’s budget constraint.

A commodity X satisfies your budget constraint if P (your price is greater than equal to M (income)

A budget line is a collection of commodity X that are just affordable, i.e., P is equal to M (income).

INCOME and PRICES are two objectives factors in budgetary constraints.

CONSUMER EQULIBRIUMDefinition-

The state of balance achieved by an end user of products that refers to the amount of goods and services they can purchase given their present level of income and the current level of prices.

Based on ORDINAL PREFERENCE or INDIFFERENCE CURVE.

ASSUMPTIONS

Fixed amount of money

Combinations of two goods

Each of the goods is HOMOGENEOUS.

Tastes and Preferences.

Consumer is rational.

CONSUMER EQULIBRIUM

Fig: Consumer Equilibrium (One commodity)

•When the commodity consumed by the consumer is available free of cost, he will carry on the consumption of the commodity up to the point, where his total utility from that commodity is maximum.

•So, he goes on consuming the commodity till extra units of the commodity give him some satisfaction.

• He stops the consumption of the commodity at the point of satiety, i.e., where marginal utility is equal to zero.

• In Fig. (a), this happens at point 'e'.

SUBSTITUTE EFFECT

When the price of commodity falls the consumer is prefer substitute more of the relatively cheaper commodity.

The larger quantity of commodity will be purchased at a lower price because the attitude of consumer.

For example, if private universities increase their tuition by 10% and public universities increase their tuition by only 2%, then it is very likely that we would see a shift in attendance from private to public universities (at least amongst students accepted to both

INCOME EFFECT This refer to the changes in the real income of the

consumer due to changes in price, when the price of commodity falls the purchasing power of real income of the consumer will rise.

Income effect may be positive, negative or zero.

 For example, a decrease in the price of all cars allows you to buy either a cheaper car or a better car for the same price, thus increasing your utility.

GIFFEN PARADOX Giffen paradox states that demand for a commodity increases as

its price rises.

Giffen paradox is explained by the fact that if the poor rely heavily on basic commodities like bread or potatoes, when prices are low they might still have some disposable income for purchases of other items.

In economics and consumer theory, a Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand.

In normal situations, as the price of a good rises, the substitution effect causes consumers to purchase less of it and more of substitute goods.

In the Giffen good situation, the income effect dominates, leading people to buy more of the good, even as its price rises.

SUPERIORITY OF INDIFFERENCE CURVE

Indifference curve analysis is superior in respect of the following:

Indifference Curve analysis is more realistic Free from the Defect of Independent Commodity Free from unrealistic assumption of Constant Marginal Utility

of money Based on Less Assumption Explanation of Income and Substitution Effects Explanation of Giffen's Paradox Helpful in the estimation of welfare More Realistic Foundation More Realistic Theory of Consumer's Equilibrium

In short, it is clear that Indifference curve analysis is more realistic and improved analysis

CriticismIndifference curve analysis criticized on account of the

following:

Unrealistic assumption Complex Analysis Imaginary Ignores combination involving risk Introspective Criticism on the basis of Indifference Assumption of Convexity Old wine in New bottles Impossible to explain Diminishing MRS without Diminishing

Marginal Utility Laughable Combinations Unrealistic Assumption of Maximum Utility Impractical