In the previous post we covered the elasticity of demand and supply. In this post we will look into consumer demand and what affects it.
Utility theory explains consumer demand based on preferences for alternative combination of goods. The satisfaction that a consumer derives from consuming a combination of goods is measured by utility.
If combination 1 has 5 biscuits and 1 tea and combination 2 has 10 biscuits and 2 teas. If the utility of combination 1 is 100 and that of combination 2 is 200 then we can say that the consumer derives more utility from the second combination. However we cannot pass any judgement on the amount of utility. We cannot say that combination 2 provides double the utility of combination 1.
Indifference curves plot the various combinations of two goods that provide equal utility, i.e. the consumer is indifferent between the various combinations.
A combination with less of good X should have more of good Y for both to have the same utility and lie on the same indifference curve.
Indifference curves are convex towards the origin. Convexity results as the slope of the curve decreases as we move towards more of good X and less of good Y as demonstrated below;
The slope of the indifference curve is called the marginal rate of substitution i.e. the rate at which a consumer will exchange Good X for Good Y. We can see from the above diagram that between A and B the consumer is willing to give up 1 unit of good X for one additional unit of Good Y. As we move down the curve between points C and D, the consumer is willing to give up two units of Good X for one additional unit of Y. From this we understand that when a consumer has more of X he is willing to give up more of X for an additional unit of Y.
In the above diagram we see that indifference curves cross. From the diagram we can derive that B has equal consumer demand to A and C, however C has more consumer demand compared to A as it has more of both the goods, X and Y.
A consumer derives equilibrium (optimal combination) at the point where the indifference curve is tangent to the budget line. The combinations on I0 are more affordable but are less preferred that I1. The combinations on I2 are more preferred than those on I1 but are less affordable than those on I1. The most preferred affordable combination of X and Y is where the indifference curve I1 is tangent to the budget line as it falls within the consumers budget.
Substitution and Income effects:
When the price of good X falls it leads to higher consumer demand for X and a consumer consumes more of good X. This is called substitution effect. As a fall in price of good X also leads to a decrease in the total expenditure of the consumer, it also has an income effect. However income effect can lead to either increase or decrease in the consumer demand of good X. If the income effect is positive the good is called a normal good as its consumption increases with an increase in income or a fall in its price. If the income effect is negative it is called an inferior good as an increase in income or fall in its price decreases its demand. (Normal goods and inferior goods were covered in detail in the last post.)
If the substitution effect is positive and the income effect is also positive, it leads to an increase in the consumer demand of Good X. If the substitution effect is positive and the income effect is negative but to a lesser extent than the substitution effect, the consumer demand of good X will increase. If the substitution effect is positive but the income effect is negative and to a larger extent than the substitution effect, it will lead to a decrease in the consumer demand of good X.
Giffen good and Veblen good:
A Giffen good is an inferior good for whom the negative income effect outweighs the positive substitution effect when the price falls and therefore its demand falls. A Giffen good has an upward sloping demand curve as more quantity is demanded at higher prices as against lower prices.
A Veblen good is one which is more desirable at higher prices. For example, status goods.
The distinction between Giffen goods and Veblen goods is that, Giffen goods are inferior goods while Veblen goods are not.
That’s all in this post …..Thanks for reading….in the next post we will learn about accounting, normal and economic profits…bye for now
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For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.