Consumer Theory PDF

**Consumer theory** is the study of how people decide to spend their money based on their individual preferences and budget constraints. A branch of microeconomics, consumer theory shows how individuals make choices, subject to how much income they have available to spend and the prices of goods and...

**Consumer theory** is the study of how people decide to spend their money based on their individual preferences and budget constraints. A branch of microeconomics, consumer theory shows how individuals make choices, subject to how much income they have available to spend and the prices of goods and services. Understanding Consumer Theory Individuals have the freedom to choose between different bundles of goods and services. Consumer theory seeks to predict their purchasing patterns by making the following three basic assumptions about human behavior: Utility maximization: Individuals are said to make calculated decisions when shopping, purchasing products that bring them the greatest benefit, otherwise known as maximum utility in economic terms Non-satiation: People are seldom satisfied with one trip to the shops and always want to consume more Decreasing marginal utility: Consumers lose satisfaction in a product the more they consume it The Substitution Effect The substitution effect is the consumer's response to a changing price to restore balance in the ratios of marginal utility to price. Economists often use the term utility as a hypothetical quantitative value for satisfaction that a consumer receives from a pattern of consumption. If a consumer were to receive one more unit of some good or service, the resulting increase in their utility is called the marginal utility of the good (increase in satisfaction that results from a consumer receiving one more unit of some good or service). The Income Effect As the result of price changes and substitution, the consumer's overall utility may increase or decrease. Consequently, the consumer may experience the equivalent of an increase or decrease in wealth, in the sense that it would have required a different level of wealth to just barely afford the new consumption pattern under the previous set of prices. This equivalent change in purchasing power is called the income effect. Understanding Giffen Goods An interesting exception is the case of Giffen goods, which is a situation where consumption of a good or service may increase in response to a price increase or decrease in response to a price decrease. This anomaly is explained by a strong income effect. Demand Demand in common parlance means the desire for an object This means that the demand becomes effective only it if is backed by the purchasing power in addition to this there must be willingness to buy a commodity. Thus demand has three essentials -- price, quantity demanded and time. Law of Demand Law of demand shows the relation between price and quantity demanded of a commodity in the market. In the words of Marshall, "the amount demand increases with a fall in price and diminishes with a rise in price". The law of demand may be explained with the help of the following demand schedule. How Each Determinant Affects Demand Each factor\'s impact on demand is unique. When the income of the buyer increases, for example, that could also increase demand. The buyer has more money and is more likely to spend it. But when other factors increase---like the price of related goods, for example--- demand could decrease. Before breaking down the effect of each determinant, it\'s important to note that these factors don\'t change in a vacuum. All the factors are in flux all the time. To understand how one determinant affects demand, you must first hypothetically assume that all the other determinants don\'t change. \(1) Price The law of demand states that when prices rise, the quantity of demand falls. That also means that when prices drop, demand will grow. People base their purchasing decisions on price if all other things are equal. The exact quantity bought for each price level is described in the demand schedule. It\'s then plotted on a graph to show the demand curve. If the quantity demanded responds a lot to price, then it\'s known as elastic demand. If demand doesn\'t change much, regardless of price, that\'s inelastic demand. \(2) Income When income rises, so will the quantity demanded. When income falls, so will demand. But if your income doubles, you won\'t always buy twice as much of a particular good or service. There\'s only so many pints of ice cream you\'d want to eat, no matter how wealthy you are, and this is an example of \"marginal utility.\" The first pint of ice cream tastes delicious. You might have another. But after that, the marginal utility starts to decrease to the point where you don\'t want any more. \(3) Prices of related goods or services The price of complementary goods or services raises the cost of using the product you demand, so you\'ll want less. The opposite reaction occurs when the price of a substitute rises. When that happens, people will want more of the good or service and less of its substitute. That\'s why Apple continually innovates with its iPhones and iPods. As soon as a substitute, such as a new Android phone, appears at a lower price, Apple comes out with a better product. Then the Android is no longer a substitute. \(4) Tastes When the public's desires, emotions, or preferences change in favor of a product, so does the quantity demanded. Likewise, when tastes go against it, that depresses the amount demanded. Brand advertising tries to increase the desire for consumer goods. \(5) Expectations When people expect that the value of something will rise, they demand more of it. \(6) Number of buyers in the market The number of consumers affects overall, or "aggregate," demand. As more buyers enter the market, demand rises. Modeling Consumer Demand To develop a formal model of consumer demand, the first step is to identify the most important determinants of demand and define variables that measure those determinants. Ideally, we should use variables for which data exist so that statistical estimation techniques can be applied to develop an algebraic relationship between the units of a good consumed and the values of the key determinants. Techniques to derive these algebraic relationships from historical data are outside the scope of this text, but an interested reader may want to consult a text on econometrics. Elasticity of Demand In economics, we define the demand elasticity of a commodity with respect to its price because demand depends on price. It indicates the extent to which demand changes when price of the commodity changes. Formally, it is defined as the ratio of the relative variations in the price. In other words, price elasticity of demand is a ratio of two pure numbers; the numerator is the percentage change in quantity demanded and the denominator is the percentage change in the price of the commodity. In fact instead of percentage change, one can also take proportionate change. Denoting elasticity by, we have Types of Demand Elasticities \(1) Price Elasticity of Demand It is the degree of responsiveness of the demand for a commodity to a change in price. This concept was introduced by Alfred Marshall. It is defined as the ratio of the percentage of change in the quantity demanded to a change in price. \(2) Income Elasticity of Demand This measures the degree of responsiveness of quantity demanded of commodity or goods with respect to a change in the level of income of a consumer, other things remaining constant (like prices etc.) \(3) Cross Elasticity Demand is also influenced by prices of other goods and services. The responsiveness of quantity demanded to changes in price of other goods is measured by cross elasticity, which is defined as the % change in the quantity demanded of one good caused by a 1% change in the price of some other good. For large changes in the price of Y, Arc cross elasticity is used. Point cross elasticity are analogous to the point elasticity Cross price elasticity for Substitutes: Negative Cross price elasticity for complementary goods is: Positive \(4) Promotional (Advertising) Elasticity of Demand Salient features of relationship between advertising and sales are the following: Some sales are possible even if there are no advertising Beyond the minimum level of sales, there is a direct relationship between advertising expenditure and sales (sales increase with increase in advertisement expenditure and decrease with decrease in advertisement sales) Consumers generally need a minimum level of advertisement before they take notice of the presence of the product. So sales do not respond to the same extent as advertisement expenditure Consumption Decisions From the name itself, consumption decision refers to the discretion of consumers whether they will purchase a product/commodity. There are three main factors affecting consumption decisions: Budget Constraint line- shows what consumers can afford. In a budget constraint line, the quantity of one good is measured on the horizontal axis and the quantity of the other good is measured on the vertical axis. The budget constraint line shows the various combinations of two goods that are affordable given consumer income. Total Utility- satisfaction derived from those choices The timeframe can also influence consumption decisions. Economists distinguish shortrun decisions from long-run decisions. Short-Run Consumption Decisions A consumer decision is considered short run when her consumption will occur soon enough to be constrained by existing household assets, personal commitments, and knowhow. Given sufficient time to remove these constraints, the consumer can change her consumption patterns and make additional improvements in the utility of consumption. Demand functions and curves in short-run Short-run demand curves are easier to develop because they estimate demand in the near future and generally do not require a long history of data on consumption and its determinant factors. Long-run Consumption Decisions Decisions affecting consumption far enough into the future so that any such adjustments can be made are called long-run decisions. Demand functions and curves in long-run Because long-run demand must account for changes in consumption styles, it requires longer histories of data and greater sophistication. Elasticity of demand in short-run and long-run Elasticities of demand in the short run can differ substantially from elasticities in the long run. Long-run price elasticities for a product are generally of higher magnitude than their short-run counterparts because the consumer has sufficient time to change consumption styles. There is so much uncertainty about long-run consumption that these analyses are usually limited to academic and government research. Short-run analyses, on the other hand, are feasible for many analysts working for the businesses that must estimate demand in order to make production decisions. Price Discrimination Price discrimination is a selling strategy that charges customers different prices for the same product or service based on what the seller thinks they can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price. How Price Discrimination Works With price discrimination, the company looking to make the sales identifies different market segments, such as domestic and industrial users, with different price elasticities. Markets must be kept separate by time, physical distance, and nature of use. Types of Price Discrimination \(1) First-degree Price Discrimination First-degree discrimination, or perfect price discrimination, occurs when a business charges the maximum possible price for each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself, or the economic surplus. \(2) Second-degree Price Discrimination Second-degree price discrimination occurs when a company charges a different price for different quantities consumed, such as quantity discounts on bulk purchases. \(3) Third-degree Price Discrimination Third-degree price discrimination occurs when a company charges a different price to different consumer groups. For example, a theater may divide moviegoers into seniors, adults, and children, each paying a different price when seeing the same movie. This discrimination is the most common