MANAGERIAL ECONOMICS

THEORY AND APPLICATIONS

CHAPTER-4
THEORY OF CONSUMER DEMAND

Chapter 4 Theory of Consumer Demand

Learning Objectives
After completing this chapter, the student should be able to:
1. 2.

Explain the law of diminishing marginal utility. Appreciate the distinction between cardinal and ordinal measurement of utility.

3.
4.

Grasp the indifference curve analysis of demand.

Compare between the Marshallian approach and Hicksian approach of the demand theory.

5.

Explain the Revealed Preference Theory.

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Law of Diminishing Marginal Utility and the Law of Demand

Utility
Utility refers to the want satisfying power of a commodity.

Demand Curve

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

Basic Assumptions of Marshallian Utility Analysis

Cardinal utility Independent utility Additive utility Constant marginal utility of money Diminishing marginal utility Rationality Introspective analysis

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

Indifferent Curve A graphic representation of various combinations of two goods, say X and Y, which is yielding equal satisfaction to the customer. Characterization of an indifference curve - Negative Slope - Convexity - No Intersection - Need not be parallel - Ordinal measurement of utility - Level of satisfaction.
Himalaya Publishing House Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

Definition. An indifference schedule is a list of alternative combinations in the stocks of two goods which yield equal satisfaction to the consumer.

The Indifference Curve

It represents all possible combinations of two goods under consideration (in this illustration, n apples and bananas), that give the consumer equal satisfaction.
Himalaya Publishing House Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Marginal Rate of Substitution

Definition. The marginal rate of substitution of X for Y (MRSxy) refers to the amount of Y that must be given up per unit of X gained by the consumer to keep the level of satisfaction unchanged.

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Budget Constraint: The Price Line

The Budget Line (Price Line)

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Consumer Equilibrium

Conditions of Consumers EquilibriumTangency : Between price line and an indifference curveConvexity : Indifference curve is convex of the point of tangency.

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

Superimposition of the Budget Line on Indifference Map

Economic Theorem. Consumer equilibrium is attained when, given his budget constraint, the consumer reaches the highest possible point in the indifference curve.
Managerial Economics Theory and Applications Dr. D. M. Mithani

Himalaya Publishing House

Chapter 4 Theory of Consumer Demand

Condition of the Consumer Equilibrium

Income Consumption Curve The curve representing income effect on demand for a product caused by the change in income of the consumer.

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Income Effect: Income Consumption Curve

Income Consumption Curve

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Price Effect: Price Consumption Curve

Definition. The income effect refers to the change in demand for a commodity resulting from a change in the income of the consumer, prices of goods being constant.

Income Consumption Curve

Himalaya Publishing House

Managerial Economics Theory and Applications Dr. D. M. Mithani

Chapter 4 Theory of Consumer Demand

The Giffen Paradox

Definition. A Giffen good is a typically inferior good having a stronger negative effect than the positive substitution effect of a fall in price, inducing a reduction in the quantity demanded.
Managerial Economics Theory and Applications Dr. D. M. Mithani

Himalaya Publishing House

Chapter 4 Theory of Consumer Demand

Superiority of Indifference Curve Approach

It is more realistic. It uses the concept of scale of preferences with lesser assumptions than the marshallian concept of utility It dispenses with the assumption of constant marginal utility of money It is wider in scope It uses concept of MRS which is scientific and measurable It exposes the conditions of consumer equilibrium in a better way
Himalaya Publishing House Managerial Economics Theory and Applications Dr. D. M. Mithani