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Lecture

Topic 6 - Consumer Demand Theory 1. Preference: -- Utility Theory -- Indifference Curve (not required) 2. Principle of Diminishing Marginal Utility 3. Consumers seek to maximize utility, subject to budget control -- Optimizing Rule; -- Exa


Department
Economics
Course Code
ECO101H1
Professor
James Pesando

Page:
of 3
ECO100Y1-Pesando-Notes edited by Eva Wu
Topic 6 Consumer Demand Theory
(Week six Oct 13th Oct 18th)
Outline:
1. Preference:
-- Utility Theory
-- Indifference Curve (not required)
2. Principle of Diminishing Marginal Utility
3. Consumers seek to maximize utility, subject to budget control
-- Optimizing Rule;
-- Example
-- Implication: Why Demand Curve Slopes downward;
4. Consumer Surplus
-- Example;
-- Willingness to pay & Steplike demand curve;
-- Linear demand curves;
5. Producer Surplus
6. Allocative Efficiency
7. What Consumers and Producers would pay to keep a market open;
Principle of Diminishing Marginal Utility
Total Utility: total satisfaction a person receives from consumption of goods;
Marginal Utility: additional satisfaction (change in total utility) from consumption of one more unit of the
product;
As a person consumes more of a good, the marginal utility of the good declines.
Numerical Example:
Movies
Per
Month
Total
Utility
Marginal
Utility
0
0
--
1
30
30
2
50
20
3
65
15
4
75
10
5
83
8
6
89
6
7
93
4
8
96
3
9
98
2
10
99
1
Quantity
Utility
ee
Total Utility
Quantity
Utility
ee
Observation:
a) TU increases with additional consumption,
but at a decreasing rate;
b) MU decreases with additional consumption;
ECO100Y1-Pesando-Notes edited by Eva Wu
Maximizing Utility
Assume consumers are rational, consumers seek to maximize total utility (satisfaction), given their budget
constraints.
1. Optimizing Rule
MUX/PX=MUY/PY for all consumed goods, x and y.
2. Example: Optimal Consumption
Apple
Beets
Quantity
TU
MU
TU
MU
0
0
--
0
--
1
80
80
100
100
2
140
60
180
80
3
180
40
240
60
4
200
20
280
40
5
210
10
300
20
Solution:
Quantity
MUA/PA for
apple
MUB/PB for
beet
0
--
--
1
40
25
2
30
20
3
20
15
4
10
10
5
5
5
Optimized combination & non-optimized combination
3 apples and 2 beets
(optimized)
5 apples and 2 beets
(non-optimized)
Total Expenditure
$14
$14
MUA/PA
20 (40/$2)
5 (10/$2)
MUB/PB
20 (80/$4)
25 (100/$4)
MUA/PA= MUB/PB ?
Yes
No
Total Utility
360
310
To maximize, given
budget constraints
No change
Consume more beets (so MUB decreases);
Consume less apples (so MUA increases)
Budget: $14/week
Goods: apple $2/ea;
Beet: $4/ea
Question: What is the combination of apples and
beets that the person should choose to gain
maximum utility?
According to optimizing rule (MUX/PX=MUY/PY),
there are three combinations:
3 apples and 2 beets
4 apples and 4 beets;
5 apples and 5 beets;
However, since the budget constraint is $14, only the
first combination costs $14, the other two exceed $14.
Therefore, 3 apples and 2 beets are the optimized
outcome.
ECO100Y1-Pesando-Notes edited by Eva Wu
3. Implication: Why do demand curves slope downwards
-- Initial Equilibrium:
MUX/PX=MUY/PY=……= MUZ/PZ (for every good you consume)
-- PX increases to PX:
MUX/PX<MUY/PY=……= MUZ/PZ (in consumption of goods when quantity is unchanged)
-- Consumer re-optimizes, by decreasing consumption of x, until:
MUX/PX=MUY/PY=……= MUZ/PZ, where MUX> MUX, which means (Q X<QX);
-- Therefore when price increases, quantity demanded decreases, therefore demand curve slopes
downward.