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CHAPTER 2
CONSUMER CHOICE
AND THE DEMAND CURVE
•
2.3 Market Demand Curve question.
Consider a final product such as alu
2.4 Price Elasticity of bhujia.1 As consumers, households are the
demanders of alu bhujia and companies like
•
Demand
Bikanerwala and Leher are the suppliers.
Another example is the service of a computer
programmer. This service is demanded by
companies or firms. Who are the suppliers of
this service? The households, because some
members of some households work as
computer programmers.
In summary, in case of final goods and
services, households demand them and firms
supply them. In case of services that are
required for production, households are the
1
Final goods and services include things that are consumed
by households, e.g. a piece of bread, a haircut, a bicycle
repair job etc. As opposed to final goods and services,
there are “intermediate” goods (or raw materials) that
are “consumed” (i.e. used up) by businesses. The
examples are steel in a bicycle factory, wheat in a flour
mill, and various automobile components in a Maruti car
workshop.
CONSUMER CHOICE AND THE DEMAND CURVE 17
suppliers and the fir ms are the unit be called “utils.” Thus, the total
demanders. utility from consuming one gol guppa
This chapter deals with households is 20 utils. Suppose that you like gol
as consumers and their demand for guppa so much that eating just one
final goods and services. How should a increases your appetite for it. Let the
consumer decide how much of a second unit give an additional utility
product to buy? What factors do affect of 22 utils. Then, the total utility from
this decision and how? consuming two gol guppas is 20+ 22 =
42 utils. In the same manner we can
2.1 CONSUMER’S EQUILIBRIUM: calculate total utility from consuming
THE BASIS OF THE LAW OF three, four or five units and so on.
DEMAND Besides total utility, there is
Let us ignore for the moment the word another important concept called
“equilibrium” or the phrase “Law of marginal utility, defined as the utility
Demand”, and focus on the question of from the last unit consumed. Thus
how much of any particular good a the marginal utility from consuming
consumer should demand (or buy) at one gol guppa is 20 and that from
a given point of time. In order to consuming two gol guppas is 22. You
understand this, we first have to learn can now notice the relationship that
a few concepts. total utility is the sum of marginal
utilities.
2.1.1 Utility Concepts Getting on with our story, your
We begin with the notion that a intensity of desire for gol guppa must
consumer derives some satisfaction fall, after consuming a certain amount,
from consuming a product; otherwise, regardless of how much you like gol
she would not demand it at all. This is guppa. Suppose that, in your case,
captured by a term called total utility, such decline in the intensity of desire
defined as the total psychological starts with the third gol guppa you
satisfaction a consumer obtains from consume. Accordingly, let the third
consuming a given amount of a unit give you utility equal to a number
particular good. Consider for example less than 22, say, 18 utils. That is, the
your consumption of gol guppa - the marginal utility and the total utility
mouth-watering small round-shaped obtained from consuming three gol
puffed puris, served with tamarind guppas are 18 and 42 +18 = 60 utils
(imli) – water and fillings.1 respectively. The next (fourth) unit
Imagine that you are hungry and gives you still less utility, say,
have come to your favourite gol guppa 14 utils, and so on.
vendor. Suppose that if you consume This pattern of marginal utility is
only one gol guppa you derive 20 called the law of diminishing
units of pleasure or utility measured marginal utility. It states that, after
in some units. Let this (psychological) consuming a certain amount of a good
1
Incase gol guppa is not known to the children, the teachers can use other popular eatable as
example to explain the concept.
18 INTRODUCTORY MICROECONOMICS
or service, the marginal utility from it with the 10th unit be -7 utils. That is,
diminishes as more and more is the marginal utility of ten gol guppas is
consumed. If you think about it, this -7 utils. (If you are crazy and still eat
law is very natural and should hold more, each additional one can only give
for any product one consumes. In fact you more negative utility.)
it is considered as a fundamental Table 2.1 summarises your
psychological law. You will see the experience with gol guppa in terms of
critical role of it a little later. marginal utility and total utility up to
Let us resume our story once again. 10 units of consumption. Columns (2)
When you have already consumed quite and (3) present the marginal and total
a few gol guppas – say 8, and you are utility schedules.
very full in your stomach – suppose
2.1.2 How many Gol Guppas will
that the next (9th) unit gives zero utility.
you consume or buy?
Imagine what will happen if you keep
gulping more. Suppose that eating the From Table 2.1, it is clear that if you
10th unit makes you vomit! This is are a rational (not crazy) consumer,
obviously not a pleasant experience and you will eat less than 10 gol guppas,
should give you negative satisfaction. since consuming 10 or more gives you
Accordingly, let the utility associated negative marginal utility. If gol guppas
0 - 0
1 20 20
2 22 42
3 18 60
4 14 74
5 11 85
6 8 93
7 4 97
8 2 99
9 0 99
10 -7 92
CONSUMER CHOICE AND THE DEMAND CURVE 19
were free, i.e., its price were zero, you example, the 5th gol guppa is worth
would have consumed 8 or 9 units at having it since it gives Rs. 11/4 =
which your total utility is at its Rs. 2.75 worth of utility, which is
maximum. But as long as you pay greater than the price.
something for it, you may not wish to What happens with the 6 th gol
consume so many. You would like to guppa is a bit different. It gives you
know how much utility you could have utility worth Rs. 8/4 = Rs. 2, which is
obtained if you had spent some equal to the price. Will you buy it? The
amount on other items, e.g., ice cream, answer is that you will be “indifferent,”
chocolate etc. In other words, exactly that is, whether or not you buy the 6th
how many gol guppas you will eat unit does not make any difference.
would depend not only on marginal However, it is clear that you will not buy
and total utility from consuming gol (consume) more than 6. Because, at any
guppas, but also on the price of gol level of consumption beyond 6, the
guppas, and, how much a rupee is marginal utility in terms of rupees is
worth to you in terms of other goods. less than the price (you can check this
We now define marginal utility of directly). Hence we have found the
answer to our query: you will buy 5 or
one rupee as the extra utility when an
6 gol guppas.
additional rupee is spent on other
available goods in general. Suppose The above comparisons between
that, for you, it is 4 utils and let the how much of marginal utility in terms
of money you get and the price you pay
price of gol guppa be Rs. 2 per piece.
implies that, at either of these two levels
Having the information on price
of consumption, the difference between
and marginal utility of a rupee, we can
the total utility in terms of money and
determine how many gol guppas you
your total expenditure on gol guppas
will consume. Consider first whether
(defined as price × quantity purchased)
you will buy just one gol guppa. From
is maximised. Table 2.2 illustrates this.
consuming only one, you obtain utility Its second column gives total utility in
equal to 20 utils (from Table 2.1). Since terms of money, defined as total utility
the marginal utility of a rupee is 4 utils, divided by the marginal utility of one
we can say that, from consuming rupee (equal to 4 utils in this example).
one gol guppa, you get utility worth Column (3) gives your total expenditure
Rs. 20/4 = Rs. 5. On the other hand, or spending on gol guppas. The last
you pay – and thus sacrifice – Rs. 2 for column gives the difference between
it. Hence you will buy the first unit. these two columns; this is like the net
Similarly, from the second unit, you gain to a consumer. We see that this
get utility worth Rs. 22/4 = Rs. 5.50, difference is maximised (equal to
while you pay only Rs. 2. Hence you Rs. 11.25) when your gol guppa
will buy the second gol guppa also. consumption is either 5 or 6.
We keep on making such Having gone through the example,
comparisons for successive units. For we can now understand why this
20 INTRODUCTORY MICROECONOMICS
Table 2.2 Difference between Total Utility in Terms of Money and Total
Expenditure
0 0 0 0
1 5 2 3
2 10.50 4 6.50
3 15 6 9
4 18.50 8 10.50
5 21.25 10 11.25
6 23.25 12 11.25
7 24.25 14 10.25
8 24.75 16 8.75
9 24.75 18 6.75
10 23 20 3
In particular, the condition (A) says This forms the basis of defining
that the marginal utility of a product in demand for a particular good by a
terms of money be equal to its price. consumer: it is the quantity of the
Sometimes, this is loosely stated as good that she is willing to buy at
“marginal utility is equal to price.” different prices within a given period
Now go back to the example once of time.
again and see that the consumer’s However, the price of a product is
equilibrium is also attained at 5 gol not the only factor that influences how
guppas, where the principle is not much a consumer should buy of that
satisfied. This possibility exists because product. For example, if there is a taste
gol guppas are not perfectly divisible: change, it will change the marginal
they cannot be measured continuously utilities from a product, and, the
like points on a straight line. If, instead, consumer’s equilibrium condition will
a product is perfectly divisible and thus be fulfilled at some other level of
can be measured continuously, for consumption even when there is no
example by weight on a weighing scale, change in price.
there will be just one level of Moreover, while our preceding
analysis is confined to one good (e.g.
consumption at which the consumer’s
gol guppa), in reality, a consumer
equilibrium is achieved, with condition
buys many goods. The consumer’s
(A) [or (B)] met.
equilibrium analysis with respect to
We do implicitly assume from now
many goods (which is outside our
on that a product is perfectly divisible
scope) suggests two other factors,
and thus treat (A) or (B) as the condition
namely, prices of related goods and
of consumer’s equilibrium.2
income. This is quite natural. If a
2.2 MEANING AND DETERMINANTS person consumes, for example, tea
OF DEMAND and coffee, then a change in the price
Our analysis of consumer’s equilibrium of tea should affect her consumption
implies that the price of a product is an of coffee and vice versa. Also, if income
important factor in determining how changes, different amounts can be
much of the product a consumer will bought even when the prices of goods
be willing to buy within a given time and services she consumes remain
period. It is because, as the product unchanged.
price changes, the ratio of marginal The last three factors just
utility to price changes so that the mentioned are called the
consumer’s equilibrium will occur at a determinants of demand. They are
different level of consumption. namely,
2
Nothing essential or important is gained by deviating from this assumption. The only modification is
that, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.
22 INTRODUCTORY MICROECONOMICS
3
Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future price
expectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weather
prediction that your village or town will be hit by a severe cyclone in the next three days. You would
then anticipate that supply interruptions would occur and prices of these commodities would sky-
rocket. If you are a rational consumer, you would buy more of these commodities now (and store them)
even if prices, income or tastes do not change.
Moreover, taste changes can occur not only because of natural changes in a person’s liking, but also due
to advertising of products.
CONSUMER CHOICE AND THE DEMAND CURVE 23
4
An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreases
and therefore she is willing to pay less per unit. This can be turned around to say that if the price of a
product falls, a consumer buys more of it.
24 INTRODUCTORY MICROECONOMICS
Table 2.5 Effect of an Increase in the Price of Coffee on Demand for Tea
150 20 28
170 11 18
190 5 10
210 2 7
230 1 4
CONSUMER CHOICE AND THE DEMAND CURVE 25
Table 2.6 Effect of an Increase in the Price of Tea on Demand for Sugar
5 20 12
8 14 7
11 9 4
14 6 2
17 5 1
buy more or less of a product. If she those, for which demand falls as
buys more (e.g. ice cream), then we say income rises.
that the product in question is a normal
Table 2.7 presents numerical
examples of both normal and inferior
goods. Observe that, at any given price,
as income increases, quantity
demanded of the normal good increases
(by comparing columns (2)-(3)) and that
of the inferior good decreases (by
comparing columns (5)-(6)). These are
graphed in figs. 2.4 and 2.5. The
original demand curve for the normal
good, when income is Rs. 300, is
indicated by the line NN0 in fig. 2.4.
This represents the column pair (1)-(2).
Fig. 2.3 Change in demand due to The new demand curve, when income
increase in the price of a
of Rs. 400, is marked by NN 1 that
complementary good
represents the column pair (1)-(3).
good. If she buys less (e.g. peanuts), Hence an increase in income shifts the
then we say that it is an inferior good. demand curve to the right if the good
Put differently, nor mal goods are is nor mal. For the inferior good,
those, for which demand increases as the demand curves are indicated
income increases. Inferior goods are by FF 0 (original) and FF 1 (new) in
1 15 19 3 20 15
2 12 16 4 17 12
3 9 13 5 14 9
4 7 11 6 11 6
5 5 9 7 8 3
6 3 7 8 5 0
CONSUMER CHOICE AND THE DEMAND CURVE 27
pair (1)-(5) gives the market demand what we can call, the distribution
schedule. Note that for each row (price), of income;
the entry in column (5) is the sum of (c) consumers’ tastes
corresponding entries in columns (2),
(3) and (4). (d) the number of consumers who buy
These individual demand schedules the product, or what we can call, the
and the market demand schedule are market size.5
graphed in fig. 2.7. Amar’s, Akbar’s and 2.4 PRICE ELASTICITY OF
Anthony’s demand curves are DEMAND
respectively marked by their names.
The right most line is the market We have seen how various factors like
demand curve. This is obtained by own price and income affect the demand
horizontally summing the individual for a commodity. The direction of
demand curves. change was our focus - whether the
quantity demanded increases or
What are the determinants of the
decreases as price, income or other
market demand curve? They are the
factors change. The concept of elasticity
determinants of the individual demand
captures the magnitude of change or
curve described earlier plus how many
the degree of responsiveness. For
consumers buy the product, that is,
example, the price elasticity of demand
(a) prices of related goods; quantifies the effect of a change in own
(b) income levels across individuals, or price on the quantity demanded.
Table 2.8 Individual and Market Demand Schedules for Gulab Jamun
1 7 15 13 35
2 6 10 10 26
3 5 6 8 19
4 4 3 7 14
5 3 1 6 10
6 2 0 5 7
5
Many multinational firms today look at the Indian or the Chinese market as very lucrative, because of
their market sizes, which refer to the huge number of consumers in these countries.
30 INTRODUCTORY MICROECONOMICS
2.4.1 Definition and Formulas Along a given demand curve, let the
original price be P0 and the original
Formally, Elasticity of demand is quantity be Q0. Suppose that the price
defined as increases to P 1 and the quantity
demanded falls to Q1. Then the %
(C ) Price elasticity of demand = e D changes in price and quantity
% change in the quantity demanded demanded are respectively equal to
=− [(P1–P0)/P0]×100 and [(Q1–Q0)/Q0]×100.
% change in the own price
Thus (C) can be written as
Since the changes in price and
(Q1 − Q0 ) / Q0
quantity along a demand curve occur (D ) e D = − .
in opposite directions, the ratio of % (P1 − P0 ) / P0
change in quantity demanded and that If we further denote a change in
in the own price is negative in sign. quantity as ∆Q and a change in price
Hence attaching a negative sign in front
of the ratio makes the sign of eD positive. as ∆P, we can also write
Some other textbooks define the price ∆Q/Q0
elasticity the same way as above, except (E ) eD = − .
∆P / P0
for the “minus” sign. But there is no
reason to get confused. Strictly speaking, Consider the following numerical
our definition gives the absolute value example. Suppose that in your home
of the elasticity, which is, often, referred town, rasgoolas were being available at
to as “elasticity”. Rs. 5.00 per piece and the residents of
CONSUMER CHOICE AND THE DEMAND CURVE 31
the town were buying 1200 rasgoolas D1D0 along DD). This implies that,
per day. Now they become more while the % change in price is the
expensive for some reason, at Rs. 5.50 same along both demand curves,
per piece. Fewer people are eating the % change in quantity demanded
rasgoolas and many who eat, are eating is greater along DD´. Therefore,
less. Suppose that the people in the price elasticity associated with DD´
town are now buying 960 rasgoolas per is higher.
day. What is the price elasticity of 3. Higher the value of the price
demand? elasticity, greater is the degree of
We have to do some arithmetic. The responsiveness of quantity
% change in the price is equal to demanded to price. In particular, if
[(5.50 – 5.00)/5.00] ×100 =10. The % eD>1, then the % change in quantity
change in quantity is equal to [(960 – demanded must exceed the %
1200)/1200] ×100 = – 20. Hence, eD, the change in price. We then say that
price elasticity, is equal to 20/10 = 2. the product demand is elastic (e.g.
jewellery). If eD<1, the % change in
Properties
quantity demanded is less than that
1. A very desirable property of the of the price, and, we say that the
elasticity formula in measuring the product demand is inelastic.
degree of responsiveness is that it Typically, the demand for luxury
is independent of the choice of goods is elastic and that for
units. It is because any percentage necessary goods (e.g. basic food
change of a variable is independent items) is inelastic. Finally, if eD =1, it
of units. is said that the demand is unitarily
2. If two demand curves intersect, at elastic. In this special case, the
their point of intersection, the demand curve takes a particular
elasticity associated with the
flatter demand curve is higher. This
is exhibited in fig. 2.8. The demand
curves DD and DD´ intersect at the
point C. At this point, P0 is the price
of the product. The claim is that, at
price P0, the elasticity is greater
along the flatter demand curve DD´.
Why? Because the original quantity
demanded is the same, equal to D0,
along both demand curves, and, if
there is an increase in price, say to
P1, the quantity demanded falls
more along the flatter demand curve
(by amount D2D0 as compared to Fig. 2.8 Elasticity Comparison
32 INTRODUCTORY MICROECONOMICS
Clip 2-1
Price Elasticity Estimates
Price elasticities have been estimated for various products and services and in
the context of different countries. Five examples are reported below, four of which
are for India and one for America.
As you see, the price elasticities for food items and clothing are less than one, as
these are essential items. Note that item No. 4 is an example of a service: long
distance phone calls from PCOs. The elasticity for this item is also less than one.
It indicates that long-distance telephone calls are not a “luxury” demand anymore;
they have become a necessity in a country like India.
The item no. 5 shows that the demand for residential land in America is elastic,
equal to 1.64.
6
This is not a general property of price elasticity. It may not hold when the demand curve is not a straight
line.
7
At point B the elasticity is zero and at point A it is infinity.
8
If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on
the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economics
textbook.
36 INTRODUCTORY MICROECONOMICS
↑ eD > 1 ↓
↓ eD > 1 ↑
↑ eD < 1 ↑
↓ eD < 1 ↓
↑↓ eD = 1 No Change
CONSUMER CHOICE AND THE DEMAND CURVE 37
SUMMARY
l Total utility is equal to the sum of marginal utilities.
l A rational consumer will never consume that much of a product such
that the marginal utility from it is negative.
l At the consumer’s equilibrium, the difference between total utility in
terms of money and the total expenditure on a good is maximised.
l Consumer’s equilibrium is attained when the condition that the
marginal utility in terms of money is equal to the price is met.
l The law of demand defines demand curve, which is downward sloping.
l The demand curve is downward sloping because of the law of
diminishing marginal utility.
l The demand curve is essentially same as the downward sloping portion
of the marginal utility curve.
l A shift of the demand curve is caused by a change in the prices of related
goods, a change in income or a change in tastes.
l An increase in the price of a substitute good causes an increase in
demand or a rightward shift of the demand curve, while an increase in
the price of a complementary good causes a decrease in demand or a
leftward shift of the demand curve.
l As income increases, the demand for a product increases or decreases,
i.e., the demand curve shifts to the right or left, depending on whether
the good is normal or inferior.
9
We will see the use of the term “total revenue” in Chapters 4, 6 and 7.
38 INTRODUCTORY MICROECONOMICS
EXERCISES
Section I
2.1 Define total utility.
2.2 Define marginal utility.
CONSUMER CHOICE AND THE DEMAND CURVE 39
Section II
2.15 A person’s total utility schedule is given below. Derive her
marginal utility schedule.
0 0
1 10
2 25
3 38
4 48
5 55
2.32 How does an increase in income affect the demand curve for an
inferior good?
2.33 Define (a) complementary goods, (b) substitute goods, (c) inferior
good and (d) normal good.
2.34 Distinguish between a change in quantity demanded and a
change in demand.
2.35 How is the market demand curve derived from the individual
demand curves?
2.36 There are four consumers of a fruit called Smile. They are Isha,
Ifraah, Ila and Ibema. Their demand curves for Smile are given
below. Derive the market demand curve.
2.42 Draw a straight line demand curve. Choose any three points on
it and compare the point elasticities at these three points.
2.43 Consider the above straight line demand curve. Compare the
point elasticities between the points A, B and C.
2.44 The price elasticity is 2. The % change in price is equal to 5.
Find the % change in quantity.
2.45 The price elasticity is 0.5. The % change in quantity is 4. What
is the % change in price?
2.46 As the price of peanut packets increases by 5%, the number of
peanut packets demanded falls by 8%. What is the elasticity of
demand for peanut packets?
2.47 As the price of a product decreases by 7%, the total expenditure
on it has gone up by 3.5%. What can we say about the elasticity
of demand for this product?
2.48 The price of cauliflower goes up by 8% and the total expenditure
by a family on cauliflower goes up by 8%. What can we say
about the elasticity of demand for cauliflower by this family?
2.49 Show the effect of an increase in price on total expenditure
depending on the values of price elasticity.
2.50 A dentist was charging Rs. 300 for a standard cleaning job and
per month it used to generate total revenue equal to Rs. 30,000.
She has since last month increased the price of dental cleaning
to Rs. 350. As a result, fewer customers are now coming for
dental cleaning, but the total revenue is now Rs. 33,250. From
this, what can we conclude about the elasticity of demand for
such a dental service?
CONSUMER CHOICE AND THE DEMAND CURVE 43
Section III
2.53 Discuss how the market demand curve is derived from the
individual demand curves and the determinants of market
demand.
2.54 Explain why consumer’s equilibrium is attained when the
marginal utility of a product in terms of money is equal to its
price.
2.55 Suppose there are three consumers in a particular market:
Leander, Andre and Tim. Their demand schedules are given in
the following table.
(a) Derive the market demand schedule and plot the market demand
curve.
(b) Suppose Andre drops out of the market. Derive the new market
demand curve.
(c) Suppose Andre stays in the market and another person, Marat, joins
the market, whose quantity demanded at any given price is half of
that of Leander. Derive the new market demand curve.
2.56 Why does the demand curve slope downwards?
2.57 Explain the factors affecting the magnitude of price elasticity of demand.