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In microeconomics, demand refers to the buying behavior of a household. What does this mean?
Basically, micro economists want to try to explain three things:
Instead of looking at all consumers in the world, however, they try and model how smaller units
function: instead of asking, "How does the American market function?" they ask, "What will one
household do?" Each household, or small-scale decision-making unit, is affected by different
factors when making choices about what to buy and how much to buy. For instance, if one
household lives in Florida and another lives in Michigan, they might have different preferences
for clothing, since the climates are so different. Consumer preferences weigh heavily in a
household's buying decisions. Another factor that affects such decisions is income: a millionaire
and an average citizen will have very different purchasing choices, since they have different
budgets to work on. All buyers will try to maximize their utility, that is, make themselves as
happy as possible, by spending what money they have in the best way possible. By considering
both their preferences and their budget, they ensure that they end up with the best combination of
goods possible. Because the household is such a small unit, no household has a significant
impact on the market, and so the actions of any single household are its best effort to react to the
market price and the goods available.
In this unit on demand, we will learn how to work with graphical and mathematical models for
demand, we will observe how changes in price or income can affect demand, we will see how
consumers make choices under uncertainty, and we will apply that knowledge to calculate the
optimal purchases an individual consumer can make, given their income and the prices of goods.
Terms
Budget Constraint - The outermost boundary of possible purchase combinations that a person
can make, given how much money they have and the price of the goods in consideration.
Buyer - Someone who purchases goods and services from a seller for money.
Competition - In a market economy, competition occurs between large numbers of buyers and
sellers who vie for the opportunity to buy or sell goods and services. The competition among
buyers means that prices will never fall very low, and the competition among sellers means that
prices will never rise very high. This is only true if there are so many buyers and sellers that no
one individual has a significant impact on the market's equilibrium.
Complementary Good - A good is called a complementary good if the demand for the good
increases with demand for another good. One extreme example: right shoes are complementary
goods for left shoes.
Demand - Demand refers to the amount of goods and services that buyers are willing to
purchase. Typically, demand decreases with increases in price, this trend can be graphically
represented with a demand curve. Demand can be affected by changes in income, changes in
price, and changes in relative price.
Demand Curve - A demand curve is the graphical representation of the relationship between
quantities of goods and services that buyers are willing to purchase and the price of those goods
and services. Example:
Diminishing Returns - Concept that the marginal utility derived from acquiring successive
identical goods decreases with increasing quantities of goods.
Economics - Economics is the study of the production and distribution of scarce resources, and
goods and services.
Equilibrium Price - The price of a good or service at which quantity supplied is equal to
quantity demanded. Also called the market-clearing price.
Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because
supply is equal to demand at this point, there is no surplus or shortage.
Expected Value (EV) - How much a buyer thinks that a good or investment will be worth after
a time lapse, based on the probabilities of different possible outcomes. Usually refers to stocks
and other uncertain investments.
Giffen Good - Theoretical case in which an increase in the price of a good causes an increase in
quantity demanded.
Goods and Services - Products or work that are bought and sold. In a market economy,
competition among buyers and sellers sets the market equilibrium, determining the price and the
quantity sold.
Horizontal addition - The process of adding together all quantities demanded at each price
level to find aggregate demand
Income Effect - Income effect describes the effects of changes in prices on consumption.
According to the income effect, an increase in price causes a buyer to feel poorer, lowering the
quantity demanded, and vice versa. Although the buyer's actual income hasn't changed, the
change in price makes the buyer feel as if it has.
Inferior Good - A good for which quantity demanded decreases with increases in income.
Marginal Utility - Additional utility derived from each additional unit of goods acquired.
Market - A large group of buyers and sellers who are buying and selling the same good or
service.
Market Economy - An economy in which the prices and distribution of goods and services are
determined by the interaction of large numbers of buyers and sellers who have no significant
individual impact on prices or quantities.
Market-clearing Price - The price of a good or service at which quantity supplied is equal to
quantity demanded. Also called the equilibrium price.
Microeconomics - Subfield of economics which studies how households and firms behave and
interact in the market.
Normal Good - A normal good is a good for which an increase in income causes an increase in
demand, and vice versa.
Optimization - To maximize utility by making the most effective use of available resources,
whether they be money, goods, or other factors.
Resource - A supply of capital that can be used in an economy. Because resources are scarce,
however, there is not enough to go around.
Risk - Refers to the amount of variation in possible payoffs. A very risky investment will have
wide variation in possible payoffs, but might have a higher expected value; a less risky
investment will have a more predictable payoff, but a lower expected value.
Risk-averse - Refers to a buyer who is unwilling to invest in an investment with wide variation
in possible payoffs. Someone who is risk-averse might even refuse to invest in something with a
positive expected value if the variation in possible outcomes is too great.
Risk-loving - Refers to a buyer who is willing to invest in an investment with wide variation in
possible payoffs, in the hopes of getting a large return. In extreme cases, a risk lover might even
invest in something with a negative expected value.
Risk-neutral - Refers to a buyer who does not care about variation in possible payoffs. A risk-
neutral buyer will invest in any investment with a positive expected return, regardless of how
risky it is.
Scarcity - Goods, services, or resources are scarce if there is not enough for everyone to have
as much as they would like.
Seller - Someone who sells goods and services to a buyer for money.
Substitute Good - Refers to a good which is to some extent interchangeable with another good,
meaning that when the price of one good increases, demand for the other good increases.
Supply - Supply refers to the amount of goods and services that sellers are willing to sell.
Typically, supply increases with increases in price, this trend can be graphically represented with
a supply curve.
Wage - Price per unit of time when the good being sold is some form of labor or work (as
opposed to a physical product).
There are many factors that can affect demand quantity, including income, prices, and
preferences. Let's look at one good to see how this works. How much are you willing to pay for a
cold soda? If you recently got a raise at your job, you might not mind buying a pricier soda, even
if you don't need it. Your friend who has less money, however, might pick a generic brand, or
they might stick with tap water. Below are possible demand curves for you (with your big raise)
and your friend (without your big raise). Note that you are willing to buy more soda than your
friend is:
For example, let's say that Conan's initial demand curve for concert tickets looks like curve 1. If
Conan gets a new job, with a permanently higher income, however, his demand curve will shift
outwards, to curve 2. Why is this? Conan realizes that he has more money, and that, as long as he
doesn't lose his new job, he will always have more money. That means that he can buy more of
what he likes, and he will have a higher demand curve for all normal goods.
Shifts in Demand
Note that for any price level, Conan's demand is now higher than it was before the demand shift.
This can also occur with a change in buyer preferences. If Conan suddenly decides that he wants
to collect jazz CDs, and he now likes jazz CDs much more than he did before, his demand curve
will shift outwards, reflecting his new appreciation of jazz, and his willingness to pay more for
the same CDs, since they have become more valuable in his eyes. Shifts in demand curves are
caused by changes in income (which make the goods seem more or less expensive) or changes in
preferences (which make the goods seem more or less valuable).
Practice Problems
Problem 1.1: Nathan and Joe are shopping for video games. Nathan's demand function for video
games is Q = 30 - 3P, and Joe's demand function is Q = 48 - 4P. What will their combined
demand be if the price is $5? $11? [Solution]
Problem 1.2: Michelle is shopping for shirts. She chooses one, then notices that the shirts are on
sale, and gets another two shirts. How can you explain this with a graph? [Solution]
Problem 1.3: Jenn's parents increase her allowance, so she spends more money on candy every
week. How can you explain this with a graph? [Solution]
Problem 1.4: Kris and Tim's demand curves for playing cards look like this:
What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and
hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might
be more inclined to buy a hot dog. This tendency to change your purchase based on changes in
relative price is called the substitution effect. When the price of hamburgers goes up, it makes
hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy
fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger
price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution
effect.
The income effect also affects buying decisions when there are two (or more) goods. When the
price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to
buy fewer of both hamburgers and hot dogs.
If you look at the combined results of the income effect and the substitution effect, the total
effect is a little unclear. According to the income effect, an increase in the price of hamburgers
decreases consumption of both hamburgers and hot dogs. According to the substitution effect,
however, hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear
what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot
be sure what happens to hot dog consumption, since there is both an increase (substitution effect)
and a decrease (income effect).
Another factor influencing demand is one which marketers and advertisers are always trying to
understand and target: buyers' preferences. What do people like? When and how do they like it?
Still looking at soda, it makes sense that people drink more soda when it's hot, or when they're
eating a meal, or when they've been exercising. In these cases, buyers' preferences have changed:
they want the soda more, and are therefore willing to pay more for the same good. Likewise, if
it's snowing, fewer people will crave a cold soda, and the price they are willing to pay for a cold
soda is lower, although they may be willing to pay a little extra money for a hot coffee.
There are some exceptions, however: not all goods are normal goods. For instance, if an increase
in your income causes you to buy less of a good, that good is called an inferior good. For
instance, "poor college students" often satisfy themselves with generic soda and cheap ramen.
When they get jobs and a steady income, however, they might forego the cheap soda and ramen
in favor of Coke and pasta. In this example, the generic soda and cheap ramen are inferior goods.
Income and substitution effects change demand differently with different types of goods. For
instance, we have been looking at income and substitution effects when a buyer is faced with a
choice between two normal goods. An increase in the price of good A will cause a decrease in
consumption of A, and an increase in consumption of good B (assuming that the substitution
effect is stronger than the income effect). If good A is a normal good, and good B is inferior,
however, the results will be different.
Why is this true? Consider the case where the price of good A goes up.
If the A is still normal and B is still inferior, and the price of A falls, then the substitution effect
will cause higher consumption of A and lower consumption of B, and the income effect will
cause higher consumption of A and lower consumption of B. Because the buyer now feels richer,
they are less inclined to buy the inferior good.
Practice Problems
Problem 2.1: Which of the following are complementary goods, and which are substitute goods?
Utility
Utility and Indifference Curves
We know how to represent changes in demand as price or income changes on a graph, but how
can we show preferences? What makes buyers happy and how can we measure that happiness?
Economists use the term utility when referring to the level of happiness or satisfaction that
someone experiences from buying (or selling) goods and services: the more utility, the happier
the person. Utility is typically represented on a graph in an indifference curve. An indifference
curve represents all of the different combinations of two goods that generate the same level of
utility. What this means is that each point on an indifference curve represents a combination of
goods. All points on one indifference curve give the person the exact same amount of happiness.
For instance, if you give Jim a choice between points A and B on this indifference curve, he
won't really mind either way, he is indifferent. One shirt and two hats makes him just as happy as
two shirts and one hat, which is why both points are on the same indifference curve.
Another example that illustrates the principle of diminishing returns would be the case in which
you give Thom a choice between gold and steak. We all know that a bar of gold is worth more
than a steak, so only a fool would choose the steak over the gold, right? Thom knows this. If you
ask Thom to choose between a bar of gold and a steak, he will probably choose the gold, and be
very excited to have a bar of gold. The marginal utility of that first bar of gold is quite high. An
hour later, he will choose another bar of gold, and he will still be happy to get another bar of
gold; the marginal utility he gets from the second bar of gold might not be quite as high as the
marginal utility from the first bar, but it's still higher than the marginal utility he would get from
a steak. This will continue, bar after bar, with the added utility of each bar of gold being a little
lower than the last. Eventually, Thom will start to get hungry, and if he gets hungry enough, then
he will choose the steak over the gold, as the marginal utility from the steak will be higher than
the marginal utility from a bar of gold. Thom still knows the relative values of gold and steak,
and he knows that he is choosing something that is worth less, but in his situation, he has so
much gold that more gold makes very little difference, but a steak can make a large difference, as
he is very hungry.
Different indifference curves represent different levels of utility, and in general, more is better:
the more goods you have, the happier you are. On the graph, we see this preference for more as
an indifference curve that is further away from the origin. Thus, because curve 2 is further out
than curve 1, and represents a higher level of utility, any point on curve 2 will be preferable to
any point on curve 1, and any point on curve 3 will be preferable to any point on curves 1 or 2.
Indifference Curves
A few more important observations about one person's indifference curves: they can never cross.
Why is this true? Think about it this way: if curve 2 is supposed to make you happier than curve
1, but curve two crosses curve 1, then that means that at the point of intersection, you are
experiencing two different levels of utility, that is, you are both happy and happier at the same
time, which makes no sense. Thus, indifference curves never intersect, but move further away
from the origin with increased levels of utility.
For instance, if one good is a normal good, such as CDs, and the other good is an undesirable
good, such as Spam, the indifference curves will look like this, with the second indifference
curve being better than the first:
What if the consumer doesn't care about one of the goods, meaning that getting more or less of
that good doesn't make them happier or unhappier? For instance, replace the Spam with expired
baseball tickets. Jim likes getting CDs, but really doesn't care how many expired baseball tickets
he gets. This makes his indifference curves look like this:
Indifference Curves for Normal and Neutral Goods
Note that increasing or decreasing the number of baseball tickets makes no difference in his
indifference curve; only changing the number of CDs moves him to a different indifference
curve.
Another instance in which indifference curves behave strangely is in the case of complementary
goods. Demand for complementary goods is directly related. In other words, buying one good
increases the probability you'll buy the other good, those two goods are complementary. Mittens
are an extreme example of complementary goods: if you buy a right mitten, it is almost a sure bet
that you'll buy a left mitten. This also means that having extra stray mittens isn't likely to
increase your utility. There is virtually no difference in your happiness whether you have one
right mitten and one left mitten, or two right mittens and one left mitten. This shows up in the
following indifference curves (note that only a simultaneous increase of right and left mittens
will result in increased utility).
Utility Optimization
While it is impossible to know exactly what goes on inside a buyer's head while they are making
a decision, we can assume that a normal person will choose whichever combination will make
them as happy as possible, given their choices and their budget. On the graph, this means that
they will choose whichever combination lands them on the highest indifference curve possible.
We can see this optimization if we draw in the consumer's budget constraint on the same graph
as the consumer's indifference curves.
To draw a budget constraint, a line that shows the maximum amount of goods a buyer can
purchase with their available funds, you need to know two things: 1) how much money they
have, and 2) the prices of the two goods being considered. Once you have both pieces of
information, it is simply a matter of finding out the maximum amount of the first good you can
buy, without buying any of the second, then finding the maximum amount of the second good
you can buy, without buying any of the first. Mark these points on the graph and connect them.
To illustrate, suppose Tina has $100. She is deciding how many bottles of wine and how many
wine glasses she wants to buy. If wine costs $20 a bottle and glasses cost $5 each, then the most
wine she can buy is ($100/$20)=5 bottles. Likewise, she can buy at most ($100/$5)=20 wine
glasses. Her budget constraint would look like the darker line, while the filled area includes all of
her possible buying decisions, given the amount of money she has. Anything not included in the
colored area is out of her budget:
Tina's Budget Constraint
If we know her indifference curves, we can draw her budget constraint in with them on the same
graph. After that, it is simply a matter of finding the outermost indifference curve that is tangent
to (just barely touches) her budget constraint, and use this tangent point as her optimal
combination of wine and glasses. In this case, it is the second indifference curve that optimizes
her utility given her budget.
Why does it have to be the indifference curve that is tangent to her budget constraint? If it were
an indifference curve that crosses her budget constraint, such as the first indifference curve, then
we can see that the two points of intersection don't make her as happy as the single tangent point
in the previous graph. By picking the outermost curve that still touches her budget constraint, we
have maximized her utility. We can't pick a curve any further out, such as the third indifference
curve, since she can't afford to buy more than $100 worth of wine and glasses.
Obviously, budget constraints change with changes in income or price. For instance, if Tina now
has $125 instead of $100, her new budget constraint will be a parallel shift out from her original
budget constraint. The yellow shaded region represents the increase in possible purchases she
can make:
A Shift in Tina's Budget Constraint
On the other hand, if Tina still has only $100, but the price of wine changes from $20 a bottle to
$10 a bottle, her budget constraint will pivot to reflect this change:
Practice Problems
Problem 3.1: Kate has $12. Pretzels cost $2 a bag, and soda costs $3 a bottle. Draw her budget
constraint. If soda goes on sale for $2 a bottle, what does her new budget constraint look like?
[Solution]
Problem 3.2: Jeannette has $300. DVD's cost $30 and CD's cost $15. Draw her budget
constraint for DVD's and CD's. Draw her budget constraint if she has $360. [Solution]
Problem 3.3: J.P.'s indifference curves for beer and movies look like this:
J.P.'s Indifference Curves
Beer costs $4 and movies cost $6. If J.P. has $24, how much of each will he buy? [Solution]
Problem 3.4: Draw the indifference curves for cashmere sweaters and moth-eaten sweaters
(assuming that moth-eaten sweaters are undesirable and cashmere sweaters are desirable).
[Solution]
Problem 3.5: Lawrence is looking for tables and chairs. His indifference curves look like this:
He has $500 to spend, how many tables and chairs will he buy if chairs cost $50 and tables cost
$100? [Solution]
In some cases, buyers must make a purchase decision without knowing exactly what they're
getting for their money. Deciding whether or not to buy a good without knowing exactly what
the good is worth involves some degree of risk, as there is variation in the possible outcome. To
make these decisions, buyers have to evaluate, to their best ability, how much the goods are
really worth, and then decide how much they are willing to pay for the goods. For example, if
Jevan is interested in buying stock in a new startup, he can't be sure what will happen to the
value of his stock as time passes. The company could be a huge success, making his stock very
valuable, it could be a moderate success, making his stock somewhat valuable, or it could be a
failure, making his stock worthless. Before he decides to buy any stock, Jevan has to decide what
is the most likely outcome, and what his stock is going to be worth: that is, based on the
probability of different outcomes, Jevan has to assign the stock an expected value to compare
against the present price.
In order for Jevan to be able to calculate this expected value, he needs to account for all
possible outcomes, so that the total probability will be equal to 1: let's assume that huge success,
moderate success, and failure are the only possible outcomes, so the probability of at least one of
them occurring is equal to 1. If Jevan thinks that there is a 1 in 8 chance that the startup will be a
wild success, a 1 in 2 chance that it will be a moderate success, and a 3 in 8 chance that it will
fail, then he has accounted for all possible outcomes, since the combined probabilities are equal
to 1: (0.125 + 0.5 + 0.375) = 1
Next Jevan has to assign values to each outcome. In the event of huge success, Jevan thinks that
each share of stock will be worth $20. In the event of moderate success, each share will be worth
$5. In the event of failure, each share is worth $0. Combining all of Jevan's assumptions gives us
the following chart of his expectations:
We find that Jevan expects the stock to be worth about $5, based on his assumptions about
company performance. What this means is that Jevan will not be willing to pay more than $5 a
share for this stock, since he believes it to be worth $5 a share. He will probably be willing to
buy stock if the price is lower than $5, depending on how much he enjoys taking risks.
How would we explain it if the price is lower than $5, but Jevan decides not to buy any stock?
We know that he believes the stock to be worth $5, so we would expect him to buy stock if it is
priced lower than $5 a share. This can be explained by Jevan's openness to taking risks. Because
the future price of the stock is uncertain, and Jevan's estimate is only an estimate, if Jevan doesn't
like taking risks, that is, if he is risk-averse, then he may choose not to buy any stock, even if the
expected returns are positive; he is not willing to invest in a "good" investment because he is still
afraid of the possibility that he might lose money. Someone who is risk-averse will choose
investments with little variation in possible outcomes, and a high degree of predictability.
On the other hand, if the price of the stock is over $5, and Jevan still decides he wants to buy
stock, even though he believes it to be worth only $5 a share, then it may mean that he is risk-
loving; he is willing to enter into an expected loss on the off chance that the company will make
it big. This would be an extreme case; not all risk lovers will invest in stocks with negative
expected values. More commonly, risk lovers will make investments that have positive expected
values, but have very large variation in possible outcomes.
If Jevan is risk-neutral, then he will not buy stock with negative expected value, he will buy
stock with positive expected value, and stock with 0 expected value makes no difference to him
at all. Even if the risk is very high, if the expected returns are positive, he will make the
purchase. Even if the risk is very low, if the expected returns are negative, he will refuse to buy
stock.
Risk usually varies inversely with expected returns. That is, a high risk investment will often
yield a much higher potential payoff than a low risk investment. This difference in value can be
seen as a "reward" for buyers' willingness to take a higher risk. The "penalty" for taking a higher
risk is the possibility of losing a lot of money if the investment fails. We can see this discrepancy
in the high yields (and losses) in the stock market, which is relatively high risk, the moderate
yields of mutual funds, which are relatively moderate risk, and the low yields of government
bonds, which are relatively low risk. When a payoff is guaranteed, as with low risk investments,
the payoff is usually small, and when a payoff is uncertain, as with high risk investments, the
payoff is usually higher.
Practice Problems
Problem 4.1: Company A and Company B are both selling stock at $1 a share. If risk-neutral
Kenny wants to buy stock in either Company A or Company B, and he thinks that the possible
future values for Company A's stock are $0, $1, $5, and $20, with respective probabilities of
20%, 50%, 20%, and 10%, and that the possible future values of B's stock are $0, $1, $10, and
$100, with respective probabilities of 50%, 30%, 15%, and 5%, which stock will he pick?
[Solution]
Problem 4.2: Which of the following are high risk investments, and which are low risk?
Gold
Stocks in new companies
IRA's
Savings bonds
Lottery tickets [Solution]
Problem 4.3: What is the expected value of a stock whose possible future values are $0, $1, $10,
and $60 with respective probabilities of 25%, 50%, 20%, and 5%? [Solution]
Problem 4.4: If the current price of a stock is $7 a share, will risk-neutral Andy buy any stock if
he believes that the possible future values are $0, $2, $5, $10, and $50, with respective
probabilities of 10%, 15%, 50%, 20%, and 5%? [Solution]
Problem 4.5: What is the maximum price that risk-neutral Tamara will be willing to pay for a
stock which she believes has possible future values of $0, $5, $10, and $200, with respective
probabilities of 50%, 25%, 24%, and 1%? [Solution]