Theory of Demand

I. Introduction

In this course we have covered the supply and demand curves, and examined the economic concept of “elasticity”. Now we turn to focus solely on “demand”.

Demand is determined by price. Generally, the higher the price for a particularly good, the lower the quantity demanded. Conversely, as technological advances cause reduction in prices, the quantity demanded increases. Far more people own computers today than when they were first introduced over twenty years ago. Why? Simply because computers are cheaper today.

The sensitivity of the quantity demanded to a change in price is measured by the elasticity, which we discussed in the last lecture. This time, we are going to focus on other aspects of demand.

Let’s examine the price of a good. Does the amount you have to pay for a good at a given time tell the whole story about its price? Is its true price simply the number of dollars and cents demanded by the seller?

Not exactly. It is a bit more complicated than that. The relative price of a good is more important than its isolated price. When you go into a store to shop, you compare prices of different goods before choosing the one you like. Premium gasoline may look a good deal until the customer sees that regular gasoline is selling for 12 cents less.

The real price of a good is its opportunity cost. Recall what the opportunity cost is: it is the value of the best forgone alternative. When someone buys something for $10, the real cost is the best alternative use of that $10. The real price of watching television for one hour is value of that time if you had spent it in the best way possible. The price is thus not $0. The real price of that hour of television watching is your highest hourly wage if you worked, or your future wages made possible by studying now.

Defining real price in terms of opportunity cost avoids the havoc that inflation causes with prices. Back in the late 1970s, inflation was more than 10% per year. What cost $10 one year would cost $11 the next year, and over $12 in the third year. If a good kept the same price during those three years, then its opportunity cost and real price actually decreased. Think about that.

Economists created something called the Consumer Price Index, or CPI, to measure changes in basic prices of many goods over time. It looks at the typical purchases by urban (not farming) families and monitors the change in prices of those goods and services from month-to-month. It includes the costs of food, beverages, housing, clothes, transportation, medical care, recreation, education, and even services like haircuts. It then combines all those values into one number. To make it easier to compare, the values are combined in a way that the CPI for the period 1982-84 averaged 100. In January 2004, the CPI was 185.2. You can view all the numbers back nearly a hundred years at: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

By comparing a change in price of a good to the change in the CPI, you can tell whether the real price of the good is becoming more or less expensive. If the good’s price increases by less than the CPI’s increase, then the good has a real price that is falling.

II. Income and Substitution Effects

When the real price of a good decreases, then there are two economic effects. First, it increases the real income of consumers because they do not have to spend as much on the good. For example, if you drink a gallon of milk each week and the price of that gallon decreases by 25 cents, then you have 25 cents extra to spend on something else. It is as though your income went up by 25 cents. This is called the income effect.

Remember how we discussed that an increase in income usually causes people to buy more of a good? Now that you have more income, you may want to buy more milk. Instead of drinking a gallon a week, perhaps you can now afford to drink a gallon and a quart a week. The decrease in price of milk created an income effect (increase in income), which encourages you to buy more milk.

Second, the decrease in price of a good causes a substitution effect. You may want to buy more of the good instead of something else. In the milk example, its cheaper price makes it more attractive to purchase. You may want to substitute milk for the fruit juice you used to drink.

Both the income effect and the substitution effect give you an incentive to buy more of the good that decreased in price. The overall increase in quantity demanded for a good that cut its price is the sum of the income effect and the substitution effect. For a normal good, a decrease in its price causes an increase in real income (the income effect) and an increase in substitution for other goods (the substitution effect), which add together to cause an overall increase in demand.

Is that true for all goods? Last class, we mentioned an odd type of good known as an inferior good. You may recall that the demand for an inferior good actually increases when income decreases. Examples are margarine (because people with declining income can less afford butter). Student Eric noted that bankruptcy services are inferior, because the greater the decline in income, the more people who file for bankruptcy, and the greater the demand for those services. If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

Ponder that question further. From above, the overall change in quantity demanded is a sum of the income effect and the substitution effect. The income effect when the price decreases is that real income goes up. But for an inferior good, an increase in income means a decrease in demand! That’s strange. The price decreases, but the demand due to the income effect of that price decrease also decreases.

However, the substitution effect goes up when the price falls. Because the income effect and substitution effect move in opposite directions, it is difficult to predict what will happen to their sum, which is the overall demand. A Giffen good is an inferior good for which the income effect dominates, and thus it has the unusual characteristic that a fall in price of the good causes a fall in demand. It is difficult to think of an example.

It is worth defining a Giffen good again, this time in terms of a price increase: it is a good which experiences an increase in demand when its price increases. This only happens for an inferior good that responds so negatively to an increase in income that the income effect outweighs the substitution effect. In the 1895 edition of the classic Principles of Economics, Alfred Marshall wrote: As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring [British spelling] families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.

Another textbook example of a Giffen good is the potato during the terrible Irish famine of 1846-1849. The theory is that the increase in the potato price during the famine wiped out the real income of the Irish, but the potato was an inferior good that saw a surge in demand due to the reduced income. Other economists suggest that tortillas are a Giffen good in Mexico today. But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods. Rice and noodles are now described as Giffen goods among the poor in China. Do you believe it?

Except for the rare and possibly non-existent Giffen good, the Law of Demand is this: when the price of a good increases, its demand decreases. When the price of a good decreases, its demand increases. This is one of the most fundamental rules of Economics.

III. Utility

Already students have suggested that money isn’t everything. We have many expressions for this concept. There’s more to life than money. It’s only money. What’s your job satisfaction? The basic point is that dollars and cents do not capture our overall happiness or satisfaction as a consumer. You may buy the most expensive music CD on the market, or watch the most popular movie, or buy the fanciest clothes, but that does not mean you will like those items the best. Often our favorite goods are not the most expensive ones.

Utility is concept created to address that need. Total utility is defined as a consumer’s overall satisfaction. In addition, marginal utility is defined as the additional satisfaction of a consumer in buying an additional unit of a good.

Let’s take an example. Suppose you are on a family road trip by car out West. You left your campsite near Phoenix just after you woke up, and you’re driving through the desert to Los Angeles. You have not eaten all day. Hour by hour goes by and you do not see any place to eat.

Finally, at 4 in the afternoon, you see the golden arches of McDonalds appear on the horizon. You drive closer and the arches appear bigger. It’s not a mirage.

When you arrive, you run in and order its famous french fries. You’re famished. When the food arrives, you take your first handful of french fries. They seem delicious to you. Your marginal utility is extremely high. You might have paid $10 for that first mouthful of french fries because you are so hungry. Then you eat your second handful of french fries. Your marginal utility is still high, but not quite as high as the first one. You would not have paid as much for the second bit either, perhaps. By the time you finish all the french fries, the last few bites were not so satisfying. In fact, you’ve gotten sick to your stomach. The marginal utility of that last french fry was very low. Perhaps even less than zero!

You have just experienced the Law of Diminishing Marginal Utility: the marginal utility of each additional unit (e.g., french fry) always declines (in a given period).

In general, the rational consumer will always try to maximize his or her total utility. How is this done? The consumer always purchases the good with the highest marginal utility in order to maximize the total utility.

Suppose you go to a shopping mall with $80. You can buy food or clothes or anything else you find in a mall. Would you spend it all on food? Of course not. The marginal utility of your food purchases declines as you eat more. Ideally, you wouldn’t even buy enough food to fill your stomach, because you can always eat more cheaply at home. To maximize your utility, you would spend every dollar in a way that has the most marginal utility. Your first purchase would be what you want most, and then your next purchase would be your second choice, and so on. If you really want something that costs $80, then you may spend all your money on that one item.

The rational consumer maximizes utility by spending each dollar in a way to maximize marginal utility for that dollar. For such a consumer, the marginal utility of every good divided by that good’s price must be equal. MUx/Px = MUy/Py=MUz/Pz, where MUx is the marginal utility of good x and Px is the price of good x. This is known as the Law of equiproportion marginal benefit.

It is impossible for anyone else to measure your utility, or for you to try to compare your total utility to that of other consumers. What you can do is decide for yourself which goods and prices give you the greatest utility, and then buy accordingly. That may include political and religious views in addition to pure dollars and cents. For example, some conservatives boycott companies that fund abortion, regardless of how inexpensively those companies sell their goods. Such a boycott maximizes the participants’ utility, but not their savings. Many other boycotts have occurred in American history based on principles rather than price (principle, not principal!).

IV. Indifference Curve

In graphing your utility for two goods, you can construct what is known as an indifference curve. Let’s take an example. Suppose you are working on the homework for this course with three friends – Chris, Sarah and Lisa. Someone says they are hungry and go to look for snacks. You see a half-eaten bag of potato chips and you pop a bag of popcorn. However, there is not enough food for everyone, so have to ration who receives what.

You count 24 potato chips and 40 kernels of corn. Uh oh. There are four of you. On average, that’s only 6 potato chips and 10 kernels of corn per person. You tell everyone that.

But Chris likes potato chips more than corn; Sarah prefers the opposite. To decide how to allocate the food, you ask Chris and Sarah to draw their indifference curves with potato chips on the y-axis and corn on the x-axis. You learn from the curve that Chris is just as happy with 9 potato chips and 2 kernels of corn as receiving 6 potato chips and 10 kernels of corn. Chris’s utility is same in both cases. Meanwhile, Sarah is just as happy receiving 18 kernels of corn and 1 chip. Fine, you give Chris 9 chips and 2 kernels and Sarah 18 kernels and 1 chip.

Was this worth it? You bet: now you have two extra potato chips that you would not have had by splitting everything equally. Chris and Sarah are just as happy, and you can share the additional chips with Lisa.

V. Consumer Choice

Consumer surplus is the net benefit (in dollars) a consumer obtains from buying a good. Thus (consumer surplus) = (total benefit) – (total cost)

Let’s define another term: “demand price.” That is the most someone is willing to pay for something. We saw this in the homework problem about the tickets and scalpers. When you go to see a movie, there is a maximum amount you are willing to pay for a ticket. It varies for different consumers. It obviously depends on what the movie is.

A consumer’s demand price is his marginal benefit. The total benefit in the market is thus the sum of all the demand prices, which is the area under the demand curve.

The consumer surplus is the demand price (the most a consumer would pay) minus the price paid (the amount the consumer actually has to pay). Suppose you were effusive (i.e., very enthusiastic) about a particular movie, and wanted very much to see it. You were so excited that you were willing to pay $20 to see that movie. But if the theater only charges you $8, then your consumer surplus is $20 – $8 = $12.

Consumers stop buying a good when the demand price equals the price paid. For movies, the demand price falls the longer it keeps playing in a theater. After you’ve seen the movie once or twice, you’re not willing to pay so much to see it again. People stop paying to see the movie, and the theater stops playing it and begins showing a new movie instead.

VI. Assignment

Read and, if necessary, reread the above lecture. Then read the online Wikipedia for any concepts you have trouble understanding: http://en.wikipedia.org/

Alternatively, you can search Google or Yahoo! for a term and look for the Wikipedia entries.

Homework questions:

  1. The total utility of a good represents the consumer’s _________________.
  1. Bad British economic policies and a fungus wiped out the basic food supply of potatoes in Ireland between 1846 and 1849, killing 500,000 and sending many Irish to the United States. Do you think potatoes might have been an inferior good then? What would you expect the income effect of the shortage of potatoes to have been?
  1. Scott wants to maximize his lifetime income, and has to choose between working or studying. His job pays $6 per hour. Under what condition should Scott stop working at his job and start studying?
  1. Alyssa likes swimming and playing the violin. The first hour she swims she improves by 6 units of utility, and then each successive hour she improves by half the rate of the hour before it. The first hour she practices the violin she improves by 4 units of utility, then each successive hour she improves at a rate of 90% the hour before it. In 3 total hours to practice, how should she maximize her utility?
  1. Cara earns $300 a week after taxes, of which she spends $100 on transportation and other work-related expenses, $100 on 5 units of fun and $100 in savings. The price of fun is $20, but then it increases to $40. What type of effect determines how much fun Cara will buy? Cara then gets a raise to $400 a week. What type of effect determines how much fun she buys now? Explain.
  1. Suppose you manage a golf course for profit. You poll your customers and find that, each month, they value their first game at $30, their second game at $20, their third at $10, fourth at $0, and refuse to play any more in the same month. It is impractical to charge based on whether someone has previously played a round this month. How do you best charge your customers?
  1. Suppose Greg, Jessica, Charles and Abby are at a party where there is a shortage of cake and scoops of ice cream. There are only 4 pieces of cake and 4 scoops of ice cream left. Greg says he likes cake twice as much as ice cream; Jessica says the opposite. Charles prefers cake and ice cream in equal servings. Abby likes only ice cream. What servings maximize total utility?
  1. Suppose a friend of yours announced that when he has a choice between a cheaper good made in China and a more expensive good made here, he will buy the latter based on his opposition to communism. Is he being irrational?
  1. Do you think a Giffen good really exists? Can you see any possible political bias in the claim that Giffen goods exist? Your views, please.

Extra credit (4 points each for questions 10 and 11; 6 points for question 12):

  1. Let’s reconsider our fundraising dinner to promote homeschooling. Earlier we sought to maximize the profit (revenue minus expenses) from the dinner. But maximizing utility is not the same as maximizing profits. What non-profit motives might we have for a homeschool dinner? What might we do to maximize overall utility of the dinner?
  1. Last Friday I attended a fundraising dinner for a health care project for the poor. At the dinner, I learned of a new clinic in Red Bank that gives away completely free medical services. It seeks government funds to pay any malpractice claims by patients. Economically, what problems might arise for a completely free medical clinic? Do you think it will be there 20 years from now?
  1. Suppose you are a rational consumer who makes purchases by maximizing marginal utility. One day you hear that the price on a good you purchase (e.g., milk), falls by 30%. The Law of Demand says you should buy more of it. Using only the assumption that you maximize marginal utility, prove the Law of Demand as best you can.