ECON1101 Study Guide - Final Guide: Budget Constraint, Demand Curve, Real Income
The Demand Curve and the Behaviour of Consumers
Marginal Benefit
ā¢ The demand curve also indicates the MB.
ā¢ Marginal benefit (or value) ā the additional benefit of consuming or more unit of a good.
ā¢ Consumers purchase goods up until the point where Price (=MC) = MB.
ā¢ Eg: Diamond water paradox ā the price of diamonds will be high if the MB of diamonds is high,
and the price of water will be low if the MB is low. The MB of something declines the more
people consume of it. Thus, the MB of water is low even though the total benefit from water
consumption in the world is high. On the other hand, diamonds have a high MB because they
are so scarce and people consume little of them.
ā¢ The MB of something declines the more people consume of it.
ā¢ When the price of a good exceeds the MB of the first unit of a good, consumers will not
demand any of that good.
ā¢ As the price falls, consumers will demand more and more units of the good as the price of each
additional unit becomes equal to the MB of that unit.
Consumer Surplus
ā¢ Consumer surplus ā the difference between what a person is willing to pay for an additional
unit of a good (the MB) and the price paid for the good.
ā¢ CS = total consumption benefit - expenditure
ā¢ For the market as a whole, CS is the sum of all the individual consumer surpluses.
ā¢ It can be calculated as the area between the market demand curve and the market price line.
ā¢ Changes in CS can be used to measure the beneficial impact of a technology change or a policy
change that changes the market price of a good.
The Market Demand Curve
ā¢ Individual demand curve - a curve showing the relationship between quantity demanded of a
good by an individual and the price of the good.
ā¢ Market demand curve - the horizontal summation of the individual demand curves of market
participants.
ā¢ At each price, we add up how much is demanded by all individuals; the total is the market
demand at that price.
ā¢ There are two ways in which an increase in price affects quantity demanded:
1. Income effect ā price increases ā real income decreases ā QD decreases (for normal goods).
ā¢ "Real income" - the income measured in terms of what goods we can buy with it. Eg: The
purchasing power of a consumer's income is reduced even though income was unchanged.
2. Substitution effect ā price increases ā good X now relatively more expensive compared to
other goods ā substitute away from X to other relatively cheaper goods ā QD for X
decreases.
Consumer Behaviour
ā¢ Consumers choose the best bundle or mix of goods they can afford.
ā¢ Depends on:
1. Budget constraint - an income limitation on a person's expenditure on goods and services.
ā¢ The budget line - a line showing the maximum combinations of two goods that it is possible for
a consumer to buy, given a budget constraint and the market prices of the two goods.
ā¢ Slope of budget constraint/budget line = rise/run = price of good 1/price of good 2.
ā¢ Income change leads to parallel shift in budget constraint ā no change in slope.
ā¢ An increase in income will cause the budget line to shift out.
ā¢ Price change rotates budget constraint ā slope has changed.
ā¢ With an income decrease, the consumer is worse off in real terms.
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