Lecture 2-Theory of demand and supply and theory of consumer behaviour.pptx

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1. Introduction to Managerial Economics

2. Expected Learning Outcomes At the end of this unit, you will be expected to: Distinguish between demand, desire, need and want. Know the factors that affect the quantity demanded of a commodity by a household and the total market demand. Explain using either the ordinalist or cardinalist approach why consumers buy more at lower prices, than at a higher one. Distinguish between supply, existing stock and amount available. Know the factors that determine the quantity supplied of a commodity in a given market. Understand how prices are determined in the market. Explain the various reasons for and methods of government modification of the price system and equilibrium prices. Explain the various effects of changes in either quantity demanded or supplied on the equilibrium price and quantity. Explain the various types of elasticities and their importance.

3. Introduction In any economy there are millions of individuals and institutions and to reduce things to a manageable proportion they are consolidated into three important groups; namely • Households • Firms • Central Authorities These are the dramatis personae of the economic theory and the stage on which much of their play is acted is called the MARKET

4. Definition of Managerial Economics HOUSEHOLD This refers to all the people who live under one roof and who make or are subject to others making for them, joint financial decisions. The household decisions are assumed to be consistent, aimed at maximizing utility and they are the principal owners of the factors of production. In return for the factors or services of production supplied, they get or receive their income e.g. • Labour – wages and salaries • Capital – interest • Land – rent • Enterprise – profit

5. Definition of Managerial Economics THE FIRM The unit that uses factors of production to produce commodities then it sells either to other firms, to household, or to central authorities. The firm is thus the unit that makes the decisions regarding the employment of the factors of production and the output of commodities. They are assumed to be aiming at maximizing profits. CENTRAL AUTHORITIES This comprehensive term includes all public agencies, government bodies and other organisations belonging to or under the direct control of the government. They exist at the centre of legal and political power and exert some control over individual decisions taken and over markets.

6. Definition of Managerial Economics Definition and theoretical basis of demand Demand is the quantity per unit of time, which consumers (households) are willing and able to buy in the market at alternative prices, other things held constant.

7. Definition, Scope, and Nature of Business Economics ( i ) Individual and market demand schedule   The plan of the possible quantities that will be demanded at different prices by an individual is called Individual demand schedule. Such a demand schedule is purely hypothetical, but it serves to illustrate the First Law of Demand and Supply that more of a commodity will be bought at a lower than a higher price .     Price ( Kshs ) Quantity demanded per week   20 3 18 3½ 16 4 14 5 13 6 12 7 11 8 10 9   Table 2.1: The individual demand schedule

8. Structure, Conduct, and Performance (SCP) Framework Theoretically, the demand schedule of all consumers of a given commodity can be combined to form a composite demand schedule, representing the total demand for that commodity at various prices. This is called the Market demand schedule .   Price (in KShs ) Quantity demanded (per week) 20 100,000 18 120,000 16 135,000 14 150,000 13 165,000 12 180,000 11 200,000 10 240,000 9 300,000 8 350,000   Table 2.2: The market demand schedule.  

9. Importance of Managerial Economics (ii) The individual and market demand curves The quantities and prices in the demand schedule can be plotted on a graph. Such a graph after the individual demand schedule is called The Individual Demand Curve and is downward sloping. An individual demand curve is the graph relating prices to quantities demanded at those prices by an individual consumer of a given commodity The curve can also be drawn for the entire market demand and is called a Market Demand Curve: A market demand curve is the horizontal summation of the individual demand curves i.e. by taking the sum of the quantities consumed by individual consumers at each price. Consider a market consisting of two consumers:

10. Importance of Economics in Business Decision-Making

11. Business Decisions and Economic Analysis   At price P1 fig. 2:2 above, consumer 1 demands q1, consumer II demands quantity q2, and total market demand at that price is (q1+q2). At price p2, consumer 1 demands q'1, and consumer II demands quantity q'2 and total market demand at that price is (q'1+q'2). DD is the total market demand curve.

12. Business Decisions and Economic Analysis (iii) Factors influencing demand for a product   These are broadly divided into factors determining household demand and factors affecting market demand .   Factors affecting household demand   The taste of the household The income of the household The necessity of the commodity, and its alternatives if any The price of other goods

13. Business Decisions and Economic Analysis Factors affecting the total market demand These are broadly divided into the determinants of demand and conditions of demand. Own price of the product This is the most important determinant of demand. The determinants of demand other than price are referred to as the conditions of demand. Changes in the price of a product bring about changes in quantity demanded, such that when the price falls more is demanded. This can be illustrated mathematically as follows: Qd = a - bp Where Qd is quantity demanded a is the factor by which price changes p is the price

14. Business Decisions and Economic Analysis Thus, ceteris paribus, there is an inverse relationship between price and quantity demanded. Thus the normal demand curve slopes downwards from left to right as follows: D

15. Business Decisions and Economic Analysis Exceptional demand curves   There are exceptions when more is demanded when the price increases. These happens in the case of:   Inferior goods: Cheap necessary foodstuffs provide one of the best examples of exceptional demand. When the price of such a commodity increases, the consumers may give up the less essential compliments in an effort to continue consuming the same amount of the foodstuff, which will mean that he will spend more on it. He may find that there is some money left, and this he spends on more of the foodstuff and thus ends up consuming more of it than before the price rise. A highly inferior good is called Giffen good after Sir Robert Giffen.

16. Scope of Managerial Economics (ii) Articles of ostentation (snob appeal or conspicuous consumption): There are some commodities that appear desirable only if they are expensive. In such cases the consumer buys the good or service to show off or impress others. When the price rises, it becomes more impressive to consume the product and he may increase his consumption. Some articles of jewellery , perfumes- and fashion goods fall in this category.

17. Role of Microeconomics and Macroeconomics in Business Speculative demand: If prices are rising rapidly, a rise in price may cause more of a commodity to be demanded for fear that prices may rise further. Alternatively, people may buy hoping to resell it at higher prices. In all these three cases, the demand curve will be positively sloped i.e. the higher the price, the greater the quantity bought. These demand curves are called reverse demand curves (also called perverse or abnormal demand curve).

18. Scope of Managerial Economics (b) Prices of other related commodities.   Related commodities can be compliments or substitutes.   Compliments: The compliments of a commodity are those used or consumed with it. Suppose commodities A and B are compliments, and the price of A increased. This will lead to a fall in the quantity demanded of A, and will in turn lead to a fall in the demand for B. Example are bread and butter or cars and petrol.   Substitutes: The substitutes of a commodity are those that can be used or consumed in the place of the commodity. Suppose commodities X and Y are substitutes. If the price of X increases, the quantity demanded of X falls, and the demand for Y increases.

19. Scope of Managerial Economics (c) The Aggregate National Income and its distribution among the population. In normal circumstances as income goes up the quantity demanded goes up. In such a case the good is called a normal good. However, there are certain goods whose demand shall increase with income up to a certain point, then remain constant. In such a case the good is called a necessity e.g. salt. Also there are some goods whose demand shall increase with income up to a certain point then fall as the income continues to increase. In such a case the good is called an inferior good.

20. Scope of Managerial Economics Taste and preference There is a direct relationship between quantity demanded and taste. For instance, if consumers' taste and preferences change in favour of a commodity, demand will increase. On the other hand, if taste and preferences change against the commodity e.g. due to changes in fashion, demand will fall. Taste and preferences are influenced by religion, community background, academic background, environment, etc.

21. Scope of Managerial Economics Expectation of future price changes   If it is believed that the price of a commodity is likely to be higher in the future than at present, then even though the price has already risen, more of the commodity may be bought at the higher price.   (g) Climatic/seasonal factors   Seasonal variations affect the demand of certain commodities such as cold drinks like sodas and heavy clothing.  

22. Scope of Managerial Economics The size and structure of population   Changes in population overtime affect the demand for a commodity. Also as population increases, the population structure changes in such away that an increasing proportion of the population consists of young age group. This will lead to a relatively higher demand for those goods and services consumed mostly by young age group e.g. fashions, films, nightclubs, schools, toys, etc.   ( i ) Government influences   e.g. a legislation requiring the wearing of seatbelts.   (j) Advertising especially the persuasive ones  

23. Bridging Gap and Theory Movements in demand curve There are basically two movements in demand curves, namely: 1. Movement along the demand curve. Movement along the demand curve are brought by changes in own price of the commodity.

24. Role of Managerial Economics When price falls from p1 to p2, quantity demanded increases from q1 to q2 and movement along the demand curve is from A to B. Conversely when price rises from p2 to p1 quantity demanded falls from q2 to q1 and movement along the demand curve is from B to A.

25. Test Your Knowledge

26. Discussion Questions 2. Shifts in demand curve Shifts in the demand curve are brought about by the changes in factors like taste, prices of other related commodities, income etc other than the price of the commodity. The change in the demand for the commodity is indicated by a shift to the right or left of the original demand curve.   In the figure below, DD represents the initial demand before the changes. When the demand increases, the demand curve shifts to the right from position DD to positions D2D2. The quantity demanded at price P 1 increases from q 1 to q' 1 . Conversely, a fall in demand is indicated by a shift to the left of the demand curve from D 2 D 2 to DD. The quantity demanded at price P 1 decreases from q 1 to q 1  

27. THEORY OF THE CONSUMER BEHAVIOUR   Through the study of theory of consumer behaviour we can be able to explain why consumers buy more at a lower price than at a higher price or put differently why individuals or households spend their money as they do. We shall assume that the consumer is rational and aims at maximising his satisfaction, so given his income he consumes that basket of goods and services which produces maximum satisfaction. Two major theories explain the behaviour of the consumer, neither presents a totally complete picture. The first approach is the marginal utility, or cardinalist approach. The second approach centres on the indifference curve analysis or the ordinalist approach.

28. Utility   Utility is the amount of satisfaction derived from the consumption of a commodity or service at a particular time. Utility is not inherent but a psychological satisfaction, i.e. depends on the individual’s own subjective estimate of the amount of satisfaction to be obtained from the consumption of the commodity.   Marginal Utility   The extra utility derived from the consumption of one more unit of a good, the consumption of all other goods remaining unchanged.   The hypothesis of diminishing marginal utility   This states that as the quantity of a good consumed by an individual increases, the marginal utility of the good will eventually decrease.

29. Units of Total Utility/ Marginal Utility/ X consumed TU (utils) MU (utils) 0 0 0 1 15 15 2 25 10 3 33 8 4 38 5 5 40 2 6 40 0 7 39 -1

30. Consuming 1 unit of X gives 15 utils of satisfaction, consuming 2 units gives 25 utils, and so on. The figure of marginal utility decline as each successive unit is consumed. If the consumer goes on consuming more and more units, eventually he reaches a point (the sixth unit) where additional units yields no extra satisfaction at all.

31. ( i ) Marginal utility approach The downward sloping nature of the demand curve can be explained by using the law of diminishing marginal utility. For instance, consider a consumer who ahs to choose between two goods, X and Y, which have prices Px and Py respectively. Assume that the individual is rational and so wishes to maximise total utility subject to the size of the income. The consumer will be maximising total utility when his or her income has been allocated in such a way that utility to be derived from the consumption of one extra shillings worth of X is equal to the utility to be derived from the consumption of one extra shillings worth of Y.

32. In other words, when the marginal utility per shilling of X is equal to the marginal utility per shilling of Y. Only when this is true will it not be possible to increase total utility by switching expenditure from one good to another. This condition for consumer equilibrium can be written as follows:   Mux=Muy Px Py Where MUx and MUy are the marginal utilities of X and Y respectively and Px and Py are the prices (in shillings) of X and Y respectively.

33. Any number of commodities may then be added to the equation. The table below gives hypothetical marginal utility figures for a consumer who wishes to distribute expenditure of K£44 between three commodities X, Y and Z. Marginal utilities derived from each Kg of: Kg consumed x (£8/kg) Y (£4/kg) Z (£2/kg) 1 2 3 4 5 6 7   72 48 40 36 32 20 12 60 44 32 24 20 8 4 64 56 40 28 16 12 8

34. In order to maximize utility, the consumer must distribute available income so that: From the table you can see that this yields, a selection where the consumer buys 2 kg of X, 4 kg of Y and 6 kg of Z. Hence: If the consumer wishes to spend all the K£44, it is impossible to distribute it any other way which would yield greater total quality. This theorem is called the concept of equi -marginal utilities.

35. The demand curve Suppose that starting from a condition of equilibrium, the price of X falls relative to Y. We now have a condition where the utility from the last shilling spent on X will be greater than the utility from the last shillings spent on Y. Mathematically this can be written as: In order to restore the equilibrium the consumer will buy more of X (and less of Y), thus reducing the marginal utility of X. The consumer will continue substituting X for Y until equilibrium is achieved. Thus we have attained the normal demand relationship that, ceteris paribus, as the price of X falls, more of it is bought. We have therefore a normal downward-sloping demand curve. The demand curve we have derived is the individuals’ demand curve for a product.

36. (ii) Indifference Curve Analysis In the 1930s a group of economists, including Sir John Hicks and sir Roy Allen, came to believe that cardinal measurement of utility was not necessary. They argued that demand behaviour could be explained with ordinal numbers (that is, first, second, third, and so on). This is because, it is argued, individuals are able to rank their preferences, saying that they would prefer this bundle of goods to that bundle of goods and so on. Finite measurement of utility therefore becomes unnecessary and it’s sufficient simply to place in order consumers preference to investigate this we must investigate indifference curves.

37. Indifference curves In order to explain indifference curves, we will again make the simplifying assumption that the consumer buys two goods, x and y. The table below gives a number of combinations of x and y which the consumer considers to give the same satisfaction as for example, combination c of bx and 4y is thought to give the same satisfaction as D where 7x and 2y are consumed. The consumer is thus said to be indifferent as to which combination they have hence the name given to this type of analysis.

38. Combination Units of x Units of y A B C D 1 4 6 7 12 7 4 2 Table 2.3: An indifference schedule

39. An indifference curve shows the lines of combinations of the amounts of two goods say x and y such that the individual is indifferent between all combinations on that curve. At each point on the indifference curve the consumer believes that the same amount of utility is received.

40. Properties of Indifference Curves: • An indifference curve is usually convex to the origin. • Indifference curves slope downwards from left to right. • A set of indifference curves with each successive curve lying outside the previous one in a North East direction is called an indifference map. • The curves do not cross as this would isolate the axiom of transitivity of preferences. • Each curve is a graphical representation of a utility function expressed as: U = f ( x,y ) Where: u is a predetermined level of utility. x and y are two commodities to be consumed in combination to guide u.

41. The slope of the indifference curve gives the rate at which a consumer is willing to exchange one unit of a product for units of another. This is called the marginal rate of substitution. The Budget line and its economic interpretation The indifference curve shows us consumer preferences but it does not show us the situation in the market place. Here the consumer is constrained by income and by the prices of X and Y. They can both be shown by a budget line. Suppose that product X costs K£2 per unit and product Y K£1 per unit and that the consumer’s income is K£10.

42. A budget line shows all the combinations of two products which can be purchased with a given level of income. The slope of the line shows the relative prices of the two commodities. If the consumer is inside the budget line, e.g. at point E he is consuming les than the income. Thus he can consume more of X or more of Y or more of both. If he is on the budget line e.g. at point C he is spending the full budget. He is said to be consuming to budget constraint. To consume more of X e.g. moving from C to D, he must consume less of Y and vice versa. For a given budget and given price, he cannot be at a point off the budget line to the right, e.g. at point F.

43. The Consumer Equilibrium To demonstrate the consumer’s equilibrium i.e. the point at which the consumer maximizes utility with a given budget, we need to combine the indifference map and the budget line. The consumer obtains maximum utility from a budget of AF by choosing the combination of X and Y represented by C, where the marginal rate of substitution is equal to the relative prices of X and Y.

44. Inferior and Giffen Goods The substitution effect always acts in such a way that when the relative price of a good falls (real income remaining constant), more of its is purchased. The income effect, however, can work either way – when the consumer’s real income rises more or less of good x may be bought. If the less is bought, the good is said to be an inferior good. If the consumer buys less and the income effect is actually bigger than the substation effect so that the overall effect of the price fall is a decrease in consumption, then the good is said to be a Giffen Good.

45. Uses of Indifference Curve Analysis   Indifference curve analysis is useful when studying welfare economics as follows:   They are used to indicate the amount of income and leisure combination that can yield a given level of satisfaction allowing for the measure of trade off between leisure and income.   Since each indifference curve represents a given level of welfare, in an indifference map, the curve to the right represents a higher level of welfare. This is useful in analysing the effect taxation on the standard of living in an economy. A tax level may reduce the economic standard of the people and vice versa.   Employees use indifference curve analysis to decide whether to give employees housing facility in kind or in money allowance in a manner not to affect their welfare.