Demand Analysis: Consumer Behavior and Elasticity
Demand Analysis
Consumer Preferences and Indifference Curves
The demand for a good depends primarily on the tastes and preferences of individuals.
Indifference Analysis: A qualitative measure of character, which starts with tastes and preferences. It is an ordinal approach; we cannot quantify it. We assume rational behavior for these economic agents, expressed in their tastes and preferences.
Indifference curves are convex and decreasing, representing greater preference the further away they are from the origin. They cannot intersect each other.
A map of indifference curves comprises a set of indifference curves. Each successive indifference curve further from the origin (further east) reflects a higher level of total utility.
Indifference curves represent consumer preferences generically, and we can draw conclusions about them that are transferable to the properties of indifference curves:
- They are decreasing. A decrease in the consumption of one good is offset by an increase in the consumption of other goods. We could also express this as the increased consumption of a good (X) producing an increase in the total satisfaction of the individual if it is not offset by a decrease in the consumption of other goods (Y).
- Curves are convex to the origin, meaning that we value a commodity more when it is scarce. When we have an abundance of a good, we are willing to give up a unit in exchange for small amounts of an alternative good. However, when we must give up something scarce, we only maintain our utility level if each unit we relinquish is offset by increasing amounts of the other good.
- Curves further from the origin are preferred. Consumers, following the axiom of insatiability, prefer consumption baskets with a larger quantity of goods to those with less. This preference is reflected in the indifference curves. As shown in Figure 1 (not provided), higher indifference curves represent higher amounts of goods compared to lower ones, so the consumer prefers higher indifference curves.
- The transitive nature of the curves implies that the curves do not intersect, and a single indifference curve passes through every point in space.
Budget Constraint and Consumer Equilibrium
The budget constraint shows all combinations of two goods a consumer can access, given their prices (PA and PB) and the individual’s money income (M).
The representation of the budget constraint is a straight line called the budget line. Feasible combinations for the consumer lie on the budget line and within the set bounded by the axes and the line (grid area).
The consumer’s goal is to achieve the maximum possible utility from consumption. They tend to select combinations of goods located on indifference curves further from the origin because their satisfaction with them is greater. However, the limitation is given by the prices of goods and their monetary income.
Consumer Equilibrium occurs at the point where the indifference curve is tangent to the budget constraint.
As seen above, the consumer is indifferent to the specific combination they receive. So, according to market prices, one good may be substituted for another in such a way that the consumer remains as before, i.e., on the same indifference curve. It is crucial to understand the rate at which the consumer agrees to substitute one good for another in their consumption scheme.
Demand Analysis
General Analysis of Demand
Both common sense and scientific observation show that the quantity of goods purchased by individuals depends on their price. Everything else held constant (ceteris paribus), the higher the price, the lower the number of units consumers are willing to buy. The lower the market price, the more units will be purchased.
There is a clear relationship between price and the quantity purchased of a good. This relationship is called a demand schedule or demand curve.
The quantity demanded of a good consists of the number of units individuals are willing to buy at a certain price. The quantity demanded decreases as the price of the commodity in question increases, as shown in the demand curve.
The demand curve indicates the maximum amounts individuals are willing to buy at each price of the good.
Demand Function: qx = a – bpx
The demand function can also be expressed as follows:
Xd = f (Px, Po, R, G, Z)
Where:
- Px = price of good X
- Po = price of other goods
- R = income level of consumers
- G = tastes and preferences of consumers
- Z = Market size
Along the demand curve, only the price of the good changes. Income, the price of other goods, consumer tastes, and market size do not change.
When any variable other than the price of the commodity changes, such as income, tastes, prices of other goods, or market size, the demand curve shifts to a new position on the map.
The demand curve shifts to the right when:
- Consumer revenue or income increases
- The price of a substitute good increases
- The price of a complementary good decreases
- Tastes change in favor of the good
- Market size (demand) increases
The Impact of a Change in Price
To analyze different valuation methods, we must first analyze some aspects of the demand curve. It is important to separate the effect of price changes into two components:
- The substitution effect
- The income effect
The price effect has two effects:
- Substitution effect: The change in the consumption of one good due to the change in the consumption of another. It indicates the variation in the quantity demanded of a good in response to a change in its price. There is a substitution between goods.
- Income effect: The change in the purchasing power of a good due to a change in income. Faced with a decline in price, purchasing power increases with the same nominal income.
The substitution effect will never be positive. For a normal or inferior good, there will be an inverse relationship between the price change and the quantity demanded. The income effect is negative for inferior goods and positive for normal goods.
Elasticity of Demand
Price influences the quantity demanded of a good. When the price of a good changes, consumers react by demanding a different amount. Therefore, there is a causal relationship between price changes and changes in the quantity demanded.
In this respect, we can ask how strong the relationship is between price changes and changes in the quantity demanded. That is, we can determine if a price change significantly or minimally affects the amount consumers are willing to buy.
Sometimes, consumers only slightly change their quantity demanded in response to a price increase; in other cases, the change is considerable.
Elasticity is a measure of the intensity of a relationship between economic variables.
It measures the sensitivity of quantity demanded to price changes.
It indicates the percentage change in the quantity demanded of a good when its price rises by 1 percent.