Background

to Demand
 Background to Demand

Marginal Utility Theory

 MARGINAL UTILITY THEORY

■ Total and marginal utility

✜ meaning of total utility
✜ marginal utility: ∆TU/∆Q
✦ diminishing marginal utility

✜ total and marginal utility curves

 Darren’s utility from consuming crisps (daily)
16

14

12
Packets TU
10 of crisps in utils
Utility (utils)

0 0
8 1 7
2 11
6 3 13
4 14
4 5 14
6 13
2

0
0 1 2 3 4 5 6
-2

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14 TU
12
Packets TU
10 of crisps in utils
Utility (utils)

0 0
8 1 7
2 11
6 3 13
4 14
4 5 14
6 13
2

0
0 1 2 3 4 5 6
-2

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14 TU
12 Packets TU MU
of crisps in utils in utils
10
Utility (utils)

0 0 -
8 1 7 7
2 11 4
3 13 2
6
4 14 1
5 14 0
4 -1
6 13

0
0 1 2 3 4 5 6
-2

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14 TU
12 Packets TU MU
of crisps in utils in utils
10
Utility (utils)

0 0 -
8 1 7 7
2 11 4
3 13 2
6
4 14 1
5 14 0
4 -1
6 13

0
0 1 2 3 4 5 6
-2 MU
Packets of crisps consumed (per day)
 Darren’s utility from consuming crisps (daily)
16

14 TU
12 ∆TU = 2

10 ∆Q = 1
Utility (utils)

6
MU = ∆TU / ∆Q

0
0 1 2 3 4 5 6
-2 MU
Packets of crisps consumed (per day)
 Darren’s utility from consuming crisps (daily)
16

14 TU
12 ∆TU = 2

10 ∆Q = 1
Utility (utils)

6
MU = ∆TU / ∆Q = 2/1 = 2

0
0 1 2 3 4 5 6
-2 MU
Packets of crisps consumed (per day)
 MARGINAL UTILITY THEORY

■ The optimum level of consumption: the

one-commodity version
✜ consumer surplus (total and marginal)
✦ marginal consumer surplus: MU – P
✦ total consumer surplus: TU – TE
 Consumer surplus
MU, P

P1

MU

O Q1 Q
 Consumer surplus
MU, P

P1

Total
consumer MU
expenditure

O Q1 Q
 Consumer surplus
MU, P

Total
consumer
surplus
P1

Total
consumer MU
expenditure

O Q1 Q
 MARGINAL UTILITY THEORY

■ The optimum level of consumption: the

one-commodity version
✜ consumer surplus (total and marginal)
✦ marginal consumer surplus: MU – P

✦ total consumer surplus: TU – TE

✜ maximising consumer surplus: P = MU

■ Marginal utility and the demand curve

 Deriving an individual person’s demand curve
MU, P

Consumption at Q1

P1
a where P1 = MU

MU = D

O Q1 Q
 Deriving an individual person’s demand curve
MU, P

Consumption at Q2

P1
a where P2 = MU

b
P2

MU = D

O Q1 Q2 Q
 Deriving an individual person’s demand curve
MU, P

Consumption at Q3

P1
a where P3 = MU

b
P2

P3
c

MU = D

O Q1 Q2 Q3 Q
 MARGINAL UTILITY THEORY

■ Limitations of the one-commodity

version
✜ marginal utility affected by consumption of
other goods
✜ marginal utility of money not constant
■ Optimum combination of goods
✜ the equi-marginal principle
MUA/MUB = PA/PB
✜ deriving a demand curve
 Background to Demand

Risk, Uncertainty and

Insurance
RISK, UNCERTAINTY AND INSURANCE

■ Demand under conditions of risk and

uncertainty
✜ defining risk and uncertainty
✜ types of odds
✜ risk attitudes
■ Diminishing marginal utility of income
and attitudes towards risk taking
 Total utility of income

TU
Total utility

a
U1

0 5000 10 000 15 000

Income (£)
 Total utility of income

TU
b
U2
Total utility

a
U1

0 5000 10 000 15 000

Income (£)
 Total utility of income

c TU
U3
b
U2
Total utility

a
U1

0 5000 10 000 15 000

Income (£)
 Total utility of income

c TU
U3
b
U2
d
U4
Total utility

a
U1

0 5000 8000 10 000 15 000

Income (£)
RISK, UNCERTAINTY AND INSURANCE

■ Insurance: a way of removing risks

■ How insurers spread risks
✜ the law of large numbers
✜ importance of the independence of risks

■ Problems for insurers

✜ adverse selection
✜ moral hazard
 Background to Demand

Indifference Analysis
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
Constructing an indifference curve

Pears Oranges Point

30 6 a
24 7 b
20 8 c
14 10 d
10 13 e
8 15 f
6 20 g

Combinations of pears and

oranges that Clive likes
the same amount as
10 pears and 13 oranges
 Constructing an indifference curve
30
28
Pears Oranges Point
26
24 30 6 a
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
24 30 6 a
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 c
20 8
20 c d
14 10
18 10 13 e
Pears

8 15 f
16
d 6 20 g
14
12
e
10
f
8
6 g
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
✜ the shape of an indifference curve
✜ diminishing marginal rate of substitution
 Deriving the marginal rate of substitution (MRS)
30 a
∆Y = 4 MRS = 4
26 b

∆X = 1 MRS = ∆Y/∆X
Units of good Y

20

10

0
0 67 10 20
Units of good X
 Deriving the marginal rate of substitution (MRS)
30 a
∆Y = 4 MRS = 4
26 b

∆X = 1 MRS = ∆Y/∆X
Units of good Y

20

MRS = 1
10
c
∆Y = 1 d
9
∆X = 1

0
0 67 10 13 14 20
Units of good X
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
✜ the shape of an indifference curve
✜ diminishing marginal rate of substitution
✜ an indifference map
 An indifference map
30
Units of good Y

20

10

I5
I4
I3
I2
0 I1
0 10 20
Units of good X
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
✜ the shape of an indifference curve
✜ diminishing marginal rate of substitution
✜ an indifference map
■ The budget line
✜ constructing a budget line
A budget line

Units of Units of
good X good Y

0 30
5 20
10 10
15 0

Assumptions

PX = £2
PY = £1
Budget = £30
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
Units of good Y

20 5 20
10 10
15 0

10 Assumptions

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10
15 0

10 Assumptions

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0

c Assumptions
10

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0 d

c Assumptions
10

PX = £2
PY = £1
Budget = £30

0 d
0 5 10 15 20
Units of good X
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
✜ the shape of an indifference curve
✜ diminishing marginal rate of substitution
✜ an indifference map
■ The budget line
✜ constructing a budget line
✜ effect of a change in income
 Effect of an increase in income on the budget line
40

30
Units of good Y

20

Assumptions

10 PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 Effect of an increase in income on the budget line
40

Assumptions

PX = £2
30 PY = £1
Budget = £40
Units of good Y

n
20

16
m

10 Budget
= £40
Budget
= £30
0
0 5 7 10 15 20
Units of good X
 INDIFFERENCE ANALYSIS

■ Indifference curves
✜ constructing an indifference curve
✜ the shape of an indifference curve
✜ diminishing marginal rate of substitution
✜ an indifference map
■ The budget line
✜ constructing a budget line
✜ effect of a change in income
✜ effect of a change in price
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

B1 B2

b c
0
0 5 10 15 20 25 30
Units of good X
 INDIFFERENCE ANALYSIS

■ The optimum consumption point

 Finding the optimum consumption
Units of good Y

O
Units of good X
 Finding the optimum consumption
Units of good Y

I5
I4
I3
I2
I1
O
Units of good X
 Finding the optimum consumption
Units of good Y

Budget line

I5
I4
I3
I2
I1
O
Units of good X
 Finding the optimum consumption

r
s
Units of good Y

Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X
 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
 Finding the optimum consumption

r
s
Units of good Y

Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X
 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
■ The effect of a change in income
 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
■ The effect of a change in income
✜ the income–consumption curve
 Effect on consumption of a change in income
Units of good Y

B1 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I2
B1 B2 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

Income-consumption curve

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
■ The effect of a change in income
✜ the income–consumption curve
✜ the Engel curve
Deriving an Engel curve from an income-consumption curve

Bread

I3
I2
I1
B1 B2 B3
CDs
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve

I3
I2
I1
B1 B2 B3
CDs
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve

I3
I2
I1
B1 B2 B3
CDs
Income (£)
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 CDs
Income (£)
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 CDs
Income (£)

Y1 a

Qcd1
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 CDs
Income (£)

Y2 b
Y1 a

Qcd1 Qcd2
Deriving an Engel curve from an income-consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 Qcd3 CDs
Income (£)

Y3
c
Y2 b
Y1 a

Qcd1 Qcd2 Qcd3

Deriving an Engel curve from an income-consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 Qcd3 CDs
Income (£)

Engel curve
Y3
c
Y2 b
Y1 a

Qcd1 Qcd2 Qcd3

 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
■ The effect of a change in income
✜ the income–consumption curve
✜ the Engel curve
✜ income elasticity of demand and the
income–consumption curve
Deriving an Engel curve from an income-consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 Qcd3 CDs
Income (£)

Engel curve
Y3
c
Y2 b
Y1 a

Qcd1 Qcd2 Qcd3

 INDIFFERENCE ANALYSIS

■ The optimum consumption point

✜ equating the marginal rate of substitution
with the price ratio
MRS = MUA/MUB = PA/PB
■ The effect of a change in income
✜ the income–consumption curve
✜ the Engel curve
✜ income elasticity of demand and the
income–consumption curve
✜ the effect of a rise in income on the
demand for an inferior good
 Effect of a rise in income on the demand for an inferior good
Units of good Y
(normal good)

B1 I1

O Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

b
Units of good Y
(normal good)

I2

B1 I1 B2
O Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

Income-consumption curve

b
Units of good Y
(normal good)

I2

B1 I1 B2
O Units of good X
(inferior good)
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
 Effect of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a

Price-consumption curve
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
✜ deriving the individual's demand curve
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a

I1
B1

Units of good X
Deriving a demand curve from a price-consumption curve

Fall in the

Expenditure on
all other goods
price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b
c d

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

Q1 Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d
Demand

Q1 Q2 Q3 Q4 Units of good X
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
✜ deriving the individual's demand curve
■ Income and substitution effects of a
price change
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
✜ deriving the individual's demand curve
■ Income and substitution effects of a
price change
✜ a normal good
Units of good Y Income and substitution effects: normal good

f
I1
I2
I3
I4
I5
B1 I6
QX1
Units of Good X
 Income and substitution effects: normal good

Rise in the price

of good X
Units of good Y

f
I1
I2
I3
I4
I5
B2 B1 I6
QX3 QX1
Units of Good X
 Income and substitution effects: normal good

Substitution effect
of the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX3 QX2 QX1
Substitution Units of Good X
effect
 Income and substitution effects: normal good

Income effect of
the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX3 QX2 QX1
Incom Substitution Units of Good X
e effect
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
✜ deriving the individual's demand curve
■ Income and substitution effects of a
price change
✜ a normal good
✜ an inferior good
 Income and substitution effects: Inferior (non-Giffen) good
Units of good Y

I1

I2 B1

QX1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Rise in the price

of good X
Units of good Y

f
h

I1

B2 I2 B1

QX3 QX1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Substitution effect
of the price rise
g
Units of good Y

f
h

I1

B2 B1a I2 B1

QX2 QX1
Substitution effect Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Income effect of
the price rise
g
Units of good Y

f
h

I1

B2 B1a I2 B1

QX2 QX3 QX1

Substitution effect Units of Good X
Income effect
 INDIFFERENCE ANALYSIS

■ The effect of changes in price

✜ the price–consumption curve
✜ deriving the individual's demand curve
■ Income and substitution effects of a
price change
✜ a normal good
✜ an inferior good
✜ a Giffen good (a special type of inferior
good)
Units of good Y Income and substitution effects: Giffen good

I1

I2 B1
QX1
Units of Good X
 Income and substitution effects: Giffen good

Rise in the price

of good X
Units of good Y

I1
h

B2 I2 B1
QX1QX3
Units of Good X
 Income and substitution effects: Giffen good

Substitution effect
g of the price rise
Units of good Y

I1
h

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
 Income and substitution effects: Giffen good

Income effect of
g the price rise
Units of good Y

I1
h

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
Income effect
 INDIFFERENCE ANALYSIS

■ The effect of a change in price on the

demand for other goods

■ The usefulness of indifference analysis

✜ superiority of using ordinal measures

✜ limitations of indifference analysis