begins with Basic Conditions of Demand and Supply. Demand comes
from consumers (final and intermediary) while Supply is generated by
producers using factors of production and technology. Supply and
Demand are the two side of the economic equation.
Demand in economics refers
to the willingness of a consumer to pay a given price for a given
quantity of a good or service. This reflects the taste of the
consumer, i.e., one’s wants, needs and desires subject to a
budget constraint – income and prices – assuming the price of other
goods and services remain fixed.
Modern economics began with
Demand or consumer theory which was then extended to Supply or
producer theory and finally to their interaction in different types
of Markets. Or as the great American criminal entrepreneur Al
Capone said: If there is a Demand there will be a Supply! In this
section we will examine the Consumption/Utility Function of the
individual consumer. We will then derive the Income Consumption
Curve from which the Engels Curve (income demand curve) will be
derived. We will then derive the Price Consumption Curve from which
we will then derive the Demand Curve itself.
The standard model of market
economics rests on the philosophical base laid down by Jeremy
Bentham (1748 -1832). His was the last great philosophy of the
European Enlightenment (Schumpeter 1954). All is sensation; there
is no god. Human beings seek pleasure and avoid pain. Bentham, in
his felicitous calculus’ or the calculus of human happiness,
proposed a unit measure of pleasure and pain –the utile – the
sovereign ruler of the state. Utilitarianism is the generic term
but Bentham’s brand is ethical hedonism –ethical pursuit of
pleasure. It was in the 1870s that Bentham’s felicitous calculus
was married to Newton’s calculus of motion permitting erection of
the standard model of market economics.
This atom-like unit, the
utile, exhibits distinct characteristics. First, and for
Economics most important, the willingness of a person to pay a money
price for a good or service measures how many utiles of happiness
they expect to receive in exchange. This is reification –
making concrete (money) something that is abstract (happiness).
Furthermore, it is assumed that goods are infinitely divisible.
total utility is the satisfaction of consuming a total quantity of a
good or service.
marginal utility is the additional utility yielded by consuming one
more unit of that good or service.
diminishing utility means that at some level of consumption an
additional unit yields less satisfaction than the preceding unit,
i.e. total utility increases but eventually at a decreasing
rate. Furthermore, diminishing marginal utility eventually turns
negative becoming pain not pleasure, too much of a good thing;
diminishing marginal utility means a person does not consume just one
good. One does not live by bread alone. Assuming rationality, a
person chooses that combination of two or more goods and services
that maximizes total utility. This is calculatory rationality
meaning every choice is a calculation of the number and nature of
utiles, a.k.a., happiness or pleasure.
Furthermore, in theory, the
consumer is assumed rational, i.e., one chooses between
alternative commodity combinations to maximize utility assuming:
i - perfect knowledge, that
is, the consumer is aware of all alternative commodity combinations,
their prices and resulting utility;
ii - competence, that is, a
consumer is capable of evaluating the alternatives; and,
iii – taste of a consumer is
transitive or consistent, that is, if a consumer likes A as much as
B and B as much as C then one likes C as much as A.
It is also assumed that the
consumer is only able to order commodity combinations by level of
utility, 1st, 2nd, 3rd etc. This is called ordinal measurement or
rank ordering. Thus in consumption one does not specify the actual
numeric level or utility known as cardinal measurement.
Putting all these
definitions and assumptions together we generate the consumption
U = f (x, y) where:
U is the utility derived
from consuming combinations of x and y;
is the unique taste function
of a consumer;
U is continuous meaning
there are infinite combinations yielding the same level of utility.
Put another way, U is a dense set;
a number assigned to
commodity combinations such as U5 indicates only that it is
preferable to combinations with a lower number, e.g., U4 and
inferior to U6. In other words, we can rank order preferences but
any U# has no cardinal meaning; and,
U is defined for a specified
timeframe that is long enough to allow substitution between
commodity combinations but short enough to insure constancy of taste
For any level of utility say
U’ = f (x, y) there is a locus of commodity combinations
which graphically form an indifference curve. All combinations on
that curve have the same level of utility meaning the consumer is
‘indifferent’ to any point on the curve. The indifference curve is
also called a preference or utility curve.
Usually an indifference
curve is ‘convex’ in shape reflecting that an increase in x can only
be obtained by a reduction in y, and vice versa
(B&P 4th Ed
Fig. 9.3; 5th ED Fig.
7th Ed. Fig. 9.3; R&L
13th Ed Fig.
The amount of Y that must be given up to get more X while
maintaining the same level of utility is called the marginal rate
of substitution, i.e.,
MRS = MUy/MUx where:
MRS = marginal rate of
MUy = marginal utility of y
MUx = marginal utility of x
(P&B 4th Ed
Fig. 9.4; 5th Ed 8.4;
7th Ed Fig. 9.4; R&L
13th Ed Fig.
As noted above ‘f’ in
the equation U = f (x, y) is the taste function which is
different for each consumer. Thus each consumer will have a
uniquely shaped indifference curve and different MRS. When we plot
all possible levels of U we get a set of curves forming a consumer’s
indifference map. The transitivity assumption ensures the
curves do not intersect but rather rise higher and higher.
Before considering the
Budget Constraint it is appropriate to consider the nature of goods
purchased by a consumer and how they are able to pay their prices.
Commodities are called ‘goods’ because they satisfy human want,
needs and desires.
Goods can be classified in
different ways. First, there are complementary and
substitute goods. Complementary goods are one that are consumed
together, e.g., hamburgers and French fries or IPods and IPod
docking stations. Substitute goods are alternatives to one another,
e.g., a bicycle is a substitute for a car in transportation.
There are near and distant substitutes for most goods, e.g.,
a car or a truck are near substitutes while a car and a bicycle are
there are normal and inferior goods. A normal good is one the
consumption of which increases as income increases. An inferior
good is one the consumption of which decreases as income increases.
An example of an inferior good is cheap wine. As one’s income
increases consumption of cheap wine tends to decline.
there are conspicuous consumption or Veblen goods (named after
economist Thorstein Veblen) and normal consumption goods. Veblen
goods are rare and their consumption goes up as price goes up in
distinction from normal goods whose consumption goes down as price
goes up. Conspicuous consumption goods are bought to demonstrate to
others that one can afford such luxuries.
To buy a good a consumer must pay its price. Further to Bentham’s
assumption, the money price one is willing to pay for a good or
service equals the satisfaction or utility one believes can be
extracted from that good.
To pay a price, however, one must have income. Income is earned
through work which in the standard model is disutility, i.e.,
pain. One does not work for enjoyment (if one does one earns
‘psychic’ income) but rather for the monetary income used to buy
goods and thereby derived satisfaction.
While a consumer wants to
rise as high up the indifference map as possible, one is constrained
by income (I) and the price of x and y. Thus for a given level of
income and prices a budget line or constraint can be drawn. This
constraint shows all combinations that can be purchased that exhaust
I = PxX + PyY where:
I = income
P = prices
X & Y = goods
(P&B 4th Ed
Fig. 8.1 or 9.1; 5th
Ed Fig 7.1 or 8.1;
7th Ed Fig. 9.1; R&L
One cannot consume above the
constraint and, in this model, it is irrational to consume below
(keeping cash on hand) because utility is derived only from
consuming goods & services.
The maximum amount of X or Y
one can afford (with a given income and prices) is shown by the
intercepts of the budget line and respective axes. The slope of the
budget line (rise over run) is the inverse of the price ratio,
Price Ratio = Px/Py
The slope itself is Py/Px
expressed as 1/(Px/Py). This formulation is a ‘convention’ or
tradition in economics. It represents the relative price of X and
Y, i.e., how many units of X can be bought with one unit of Y
at current prices, e.g., $2/$1= a relative price of 2.
If income varies while
prices remain fixed then a new higher budget line becomes available
to the consumer parallel to the original. In other words higher
income relaxes the constraint on one’s happiness. If, on the other
hand, the price of X (or Y) decreases the slope of the budget line
and therefore the price ratio changes. For
example if Px goes down then the intercept which measures
the maximum amount of x a consumer can afford increases even if income
The combination of x and y
that maximizes a consumer’s utility is the one on the budget line
tangent or just touching the highest attainable indifference curve
Fig. 9.4; 5th 8.4;
7th Ed Fig. 9.4; R&L
13th Ed Fig.
This is the ‘best affordable point’ (P&B
Fig. 9.6; 5th 8.6;
7th Ed Fig. 9.6; R&L
and satisfies the following conditions:
MRS = MUy/MUx = 1/(Px/Py)
that is the slope of the
indifference curve or Marginal Rate of Substitution equals the slope
of the Budget Line or the inverse of the price ratio (Px/Py) and at
this point the ‘rationale’ consumer equates the MU per dollar of
each commodity consumed or
MUx/Px = MUy/Py where
dollar-for dollar the
additional utility from an additional unit of X is equal
dollar-for-dollar to the additional satisfaction from one more unit
of Y (P&B 4th
Fig. 8.3; 5th Fig.
7.3; 7th Ed not displayed; R&L 13th Ed not displayed).
Consumers will remain at
this point, i.e., be in equilibrium, as long as taste, income
and prices remain fixed. This is the initial equilibrium. It is a
condition which once achieved continues indefinitely unless one of
the variables is altered (P&B 4th Ed
Fig. 4.8; 7th Ed
Fig. 3.7; R&L 13th Ed
For our purposes there are two types:
a) stable equilibrium: which
refers to a condition which once achieved continues indefinitely
unless there is a change in some underlying conditions. Changes in
economic conditions will be followed by reestablishment of the
original equilibrium. Example: a ball resting at the bottom of a
cup; shake it and the ball moves; stop shaking and it returns to the
bottom of the cup; and,
b) unstable equilibrium:
which refers to a condition which once achieved will continue
indefinitely unless one of the variables changes but the system will
not return to the original equilibrium. Example: a ball resting on
the top of an overturned cup - shake it and the ball falls off never
to return to the same place.
We will now change
assumptions one by one and see what happens to equilibrium.
An increase in income shifts
the intercepts of the budget line but leaves its slope constant -
assuming constant prices. The locus of tangents of budget lines
with indifference curves forms the income-consumption curve,
i.e., the set of commodity combinations (x, y) consumed as
income increases - assuming constant prices and taste
(R&L 13th Ed
From the income-consumption
curve we can derive the amount of a given commodity (x) purchased at
different levels of income. This forms the
Fig. 4.2; R&L 13th Ed not displayed)
which, in effect, is the
income demand curve for a good or service. The shape of the curve
depends on the type of commodity. A normal good will have a
positively sloped Engel Curve reflecting the fact that as income
rises, consumption rises. An inferior good will have a negatively
sloped Engel Curve reflecting that as income increases consumption
decreases. An example is Kraft Dinner. For a poor student it is a
cheap source of pasta and cheese but when the student becomes a
well-paid junior executive of a Fortune 500 company it is no longer
In business it is critical
to know if one’s product is a normal or inferior good. If consumer
income rises then sales of a normal good will increase. In a
recession, however, with falling consumer income sales of a normal
good decrease while sales of an inferior good increase.
If the price of one
commodity (X) changes a new set of combinations (X, Y) is created
between the changing tangents of the budget line and indifference
curves forming the price-consumption curve for the commodity. The
price-consumption curve shows how much of both commodities are
purchased if its price changes - assuming constant income and prices
for all other goods (R&L 13th Ed
The demand curve for a
commodity (X) can be derived from the price-consumption curve
showing how much of that commodity is purchased at different prices
- assuming constant income and constant prices for the other good
(Y). The shape of the demand curve (X) depends on taste, income and
the type of commodity - assuming constant prices for the other good
(Y) (P&B 4th Ed.
Fig. 9.7; 5th Ed.
7th Ed Fig. 9.7; R&L
The Law of Demand generally holds: the higher the price, lower the
demand; lower the price, higher the Demand. Why? The Law of
Diminishing Marginal Utility.
It is important to note that
the change in price of one good or service (assuming income and
prices of other goods remain fixed) has two effects. For example,
as the price of one good (X) declines it becomes cheaper relative to
Y. In equilibrium we have seen that consumers equates the marginal
utility per dollar of each good, i.e., MUx/Px = MUy/Py. If
the price of X goes down while the price of Y remains constant then
dollar for dollar the consumer can get more utility by substituting
x for the now more expensive y. This is called the substitution
effect. This effect holds for both normal and inferior goods.
In addition, if the price of
x goes down the consumer can now afford to buy the same amount but
have money income left over. In effect income goes up allowing the
purchase of more of both X and Y. This is called the income
The substitution effect is always negative, that
is if the price of a commodity (X) goes up, the quantity consumed
goes down. The income effect can be positive or negative. For
'normal' goods, an increase in income results in an increase in
consumption. If the quantity decreases when income increases the
commodity is an 'inferior' good. In most cases, if the price of an
inferior good decreases consumption will still increase if income
Taken together the
substitution and income effects are called the price effect
(P&B 4th Ed.
Fig. 9.8 &
Fig. 9.9; 5th Ed.
Fig. 8.8 & 8.9;
7th Ed Fig. 9.8 &
Fig. 9.9; R&L 13th Ed
M&Y 4.6 &
Elasticity refers to the
sensitivity of one variable to a one percentage change in another.
Economic theory recognizes three principal types:
income elasticity of demand
with prices constant refers to the percentage change in the quantity
of a commodity demanded compared to a one percent change in income.
If income goes up 1% what happens to demand? If it too goes up 1%
there is unitary elasticity. If demand goes up more than 1% there
is elastic demand; if it goes up less than 1% then there is
inelastic income demand for the good or service (P&B 4th Ed, Fig
5.8; 7th Ed not displayed; R&L 13th Ed not displayed);
b) price elasticity of
refers to the percentage
change in the quantity of a commodity demanded compared to a one
percentage change in its price. The amount demanded can increase:
i) more than
proportionately, i.e. elasticity is greater than one - at the
extreme a horizontal demand or supply curve is perfectly elastic - a
small increase in price results in a large change in the quantity
demanded or supplied;
ii) proportionately, i.e.
elasticity is equal to one (unitary elasticity); or,
iii less than
proportionately. i.e. elasticity is less than one (inelastic)
- at the extreme, a vertical demand or supply curve is perfectly
inelastic - any change in price results in no change in the amount
of the commodity demanded or supplied (P&B 4th Ed.
Fig. 5.8; 7th Ed
R&L 13th ED.
c) elasticity of
in the consumption of one commodity substituted for another by a
consumer in response to a change in their relative prices (P&B 4th
Fig. 5.7; 7th Ed
R&L 13th Ed not displayed).
In conclusion, consumption
is the use of a product whereby utility is destroyed. Put another
way it is ‘negative production’. Producers put utility into a good
or service to satisfy human wants, needs and desires then consumers
extract it. Income is payment for work used to buy goods and
services to obtain utility. Work is the physical or intellectual
effort made to earn income to purchase products and thereby obtain
utility. Price is the dollar and cents cost of a product which is
assumed to represent the utility a consumer can derive from it.
Symbolic Summary of Demand
U = f (x, y)
MRS = MUy/MUx
Marginal Rate of Substitution
I = PxX + PyY
MRS = MUy/MUx
= 1/(Px/Py) Consumer Equilibrium
MUx/Px = MUy/Py