Topic 4: Theory of Consumer Demand

• Consumer are the group of individuals who consume final goods and services as a means of fulfilling their wants or desires.
• Consumer demand can be defined as the total quantity of goods or services purchased over a specific period of time.
• The theory of consumer demands attempts to explain or demonstrate how consumers achieved equilibrium.
• Equilibrium in this context refers to the level of consumption at which utility is maximized, subject to the constraints of income available for spending and the prices of goods and services.
• The demand curve is derived using the substitution method.
• The equilibrium of a consumer is reached when he allocates his given income between two goods such that utility is maximized given the price of the commodity, which is referred to as equi-marginal utility or the optimal purchase rule.
• Marginal Utility Theory is subjective, relies on the economist's judgements, and has very little practical application, but it is useful for explaining consumer behaviour from a theoretical perspective.
• Marginal Utility Theory is limited in that consumer satisfaction cannot be measured using cardinal figures.
• There are two approaches or theories which are used to explain how consumers established their own equilibrium level of consumption: Cardinalist approach (Marginal utility theory) and Ordinalist approach (Indifference curve analysis).
• Utility describes the pleasure, satisfaction or benefit a person derives from the consumption of commodities over a certain period of time.
• The Cardinal Approach assumes that a consumer utility can be quantified/ quantitative term into units which are measured in to UTILS.
• A consumer may express the utility he derived from consuming a good as 10 Utils or 20 utils.
• The Ordinal Approach states that the satisfaction which a consumer derives from the consumption of good or service cannot be expressed numerical units.
• Rather the consumer can compare the utility accruing from different commodities and rank them in accordance with the satisfaction each commodities ( or combination of commodities )gives.
• Total utility is the total satisfaction that a person derives from spending income and consuming commodities during a given period of time.
• Marginal utility is the extra satisfaction gained from consuming one additional unit of a commodity over a given time period.
• Total utility and marginal utility can be represented on a graph with quantity on the x-axis and utility on the y-axis.
• Marginal utility curve is a curve that shows the marginal utility as a function of quantity.
• Total utility curve is a curve that shows the total utility as a function of quantity.
• In terms of marginal utility theory, a convenient way to conceptualize this analysis is to determine the marginal utility to price ratio.
• This ratio gives the amount of extra satisfaction derived by consumer from every dollar spent on the good.
• MU can be derived from the TU curve; it is the slope of the line joining two adjacent points.
• Total utility starts at the origin where consumption is = 0 utility.
• The law of diminishing marginal utility states that as a person consumes more and more of a commodity the total utility he gains will continue to increase but the marginal utility will probably fall with each additional unit consumed.
• Consumer decision would be based on both the marginal utility gained by him or her from the consumption of each good as well as the prices paid for each good.
• Marginal utility to price ratio: = Marginal Utility X Price.
• The marginal utility curve slopes downwards illustrating the principle of diminishing marginal utility.
• Consumer equilibrium refers to the situation, where a consumer, with limited income, achieves maximum satisfaction, without changing the manner of spending on existing expenditure.
• Marginal utility has decreased because having eaten one bun the consumer has less craving for a second bun.
• When MU = 0, TU is at its maximum.
• A rational consumer is one who weighs the cost and benefit to him/her of each additional unit of a good purchased.
• If the price of ‘x’ falls/increases then disequilibrium will occur.
• Say for instance the price of good x falls then equilibrium no longer exist.
• Good ‘x’ becomes cheaper, marginal utility price ratio increase.
• As the price of good x declines, an increased quantity is purchased/demanded/consumed, which is the first law of demand.
• Using marginal utility theory, it becomes evident that as the price of good x falls from $3 to $2, the consumer began to consume more of good x, as its marginal utility to price ratio increase.
• She purchased good x for $3 and the marginal utility gained was $150 utils and y cost $4 and the marginal utility is $200.
• Given the law of diminishing marginal utility, as more units of good x is consumed, its MU: P ratio to fall.
• This would therefore lead consumer to rate good X ahead of good Y.
• As less of good ‘y’ is consumed the MU for it increases leading to an increase in the MU: P ratio.