Unit 1 Module 1

Topic 2: Theory of Consumer Demand

Mrs. C. Mohammed-Beharry

Consumers are the group of individuals who consume final goods and services as a means of
fulfilling their wants and desires. Consumer demand can be defined as the total quantity of goods
or services purchased over a specified period of time. The first law of demand states that as the
price of a good is lowered, consumers demand a larger quantity, ceteris paribus. That is, an
inverse relationship between price and quantity demanded as shown by the downward sloping
demand curve.
Effective Demand: - refers to the quantity of a good that consumers are willing and able to
purchase at the existing price.
Price

D
Quantity Demanded

Assumptions of Consumer Demand Theory

o Consumers are utility maximizers, i.e. they try to gain as much satisfaction or utility
possible from the goods and services they choose.
o Consumers are rational, in that they aim not only to attain the greatest level of utility
from the consumption of goods and services but they also aspire to do so at the least
possible cost.
Given these assumptions, consumer demand theory demonstrates how consumers achieve
equilibrium. Equilibrium in this context refers to the level of consumption at which utility is
maximized, subject to the constraints of income available for spending and the prices of goods
and services. Income and prices are considered to be constraints, as they impose limits on the
quantity of goods and services which individuals can afford to purchase and consume.
Utility: - the level of satisfaction that consumers gain from conducting economic activity. The
assumption is made that the consumer is rational and seeks to maximize utility.

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

There are two (2) theories used to explain how consumers establish their equilibrium level of
consumption:
o The Cardinal Utility Theory
o The Ordinal Utility Theory

The Cardinal Utility Theory (or Marginal Utility Theory)

This theory, developed by Alfred Marshall (1890s) is based on measuring the utility derived
from consuming a good, using cardinal numbers. Under this theory, utility is measurable in terms
of money. The assumption of this theory is that the utility of every dollar means the same to all
consumers. The utility of money is constant. For example, the utility a person would derive from
consuming a coke soft drink may be valued at 6 utils while the satisfaction attained from the
purchase of a brand new car may be 200 000 utils.
Total Utility: the total satisfaction derived from all the units of that product consumed.
Marginal Utility: - the additional utility derived from the consumption of ONE extra unit of a
good or the change in satisfaction resulting from consuming one unit more or one unit less of
that product.
The Law of Diminishing Marginal Utility: - states that as a consumer increases consumption of
a good or service, the additional satisfaction derived from the consumption of each successive
unit will diminish. See table below.
Units of Good X consumed
0
1
2
3
4
5
Explain table

Total Utility
0
150
250
330
380
400

Marginal Utility
150
100
80
50
20

As can be seen, marginal utility declines as consumption increases thus demonstrating the law of
diminishing marginal utility.
In the case where a consumer has to choose whether to increase consumption of either good X or
good Y for example Blackberry versus Samsung Galaxy 111, the consumer must be able to
compare each good in terms of its benefits and costs. That is, it would be based on an analysis of

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

both the marginal utility gained by him/her from the consumption of each good as well as the
prices paid for each good. This can be done by calculating the marginal utility to price ratio as
shown below.
Marginal utilityx
Pricex
The ratio gives the amount of extra satisfaction derived by the consumer from every dollar spent
on the good.
For example, if consuming an extra unit of good X which costs $3 increases utility by 150 utils,
then its marginal utility to price ratio is:
150/3 = 50 utils per dollar
This means that for every dollar spent towards purchasing good X, 50 utils of satisfaction are
gained. When comparing two goods X and Y, consumption of the good which derives the highest
utility will be increased.
Marginal utilityx > Marginal utilityy
Pricex
Pricey

Increase consumption of Good X

Marginal utilityx < Marginal utilityy

Pricex
Pricey

Increase consumption of Good Y

Marginal utilityx = Marginal utilityy

Pricex
Pricey

Equilibrium is achieved.

Consider what would happen if the price of good X falls. Then equilibrium would no longer be
established. Thus:
Marginal utilityx > Marginal utilityy
Pricex
Pricey

Increase consumption of Good X

Given the law of diminishing marginal utility, as more units of good X is consumed, its marginal
utility would decrease and hence the marginal utility to price ratio for good X would fall. As less
of good Y is consumed, its marginal utility would increase causing a rise in its marginal utility to
price ratio.
Marginal utilityx
and
Marginal utilityy
Pricex
Pricey
The consumer would continue to purchase more of good X until equilibrium is achieved.
Marginal utilityx = Marginal utilityy

Equilibrium is achieved.

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Pricex

Pricey

Qu: The table shows the utility that Alex gets from the consumption of DVD movies and comic
books. Alex has $100 per month to spend on DVD movies and comic books. DVD movies cost
$20 each and comic books cost $20 each.
Quantity
0
1
2
3
4
5

Utility from DVD movies

0
30
40
48
54
58

Utility from comic books

0
30
38
44
46
47

a. Define the term marginal utility.

b. Calculate Alexs marginal utility for:
i.
DVD movies
ii.
Comic books
c. Calculate the marginal utility per dollar of Alexs consumption choices.
d. State the optimal number of DVD movies and comic books that Alex will consume in one
month.
Past Papers 2010 # 1
The Marginal Utility Curve
MU

Qt

Observe that after Q1 units of the good are consumed, the MU of the consumer becomes
negative.
The Total Utility Curve

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Utility

Units consumed
The cumulative sum of marginal utilities gives the total utility of the consumer for consuming a
commodity. Observe that TU increases rapidly from 0 to TU0 in the early stages of consuming
the commodity. As more and more of the commodity is consumed, observe that the TU curve
increases at a decreasing rate indicating that MU from each successive unit of the commodity
falls. After Q1 units of the commodity are consumed, the MU of the consumer becomes negative
and so the TU curve turns downward. MU can therefore be regarded as the slope, or rate of
change of the TU curve, where when MU = 0, the TU is at its highest and as MU becomes
negative, TU declines.
Limitation of the Marginal Utility Theory
Valuations of consumer satisfaction are highly subjective as they depend on the personal
judgement of the economist to make estimates of these values. Hence, this method is impractical
to measure utility in an objective manner.
The Ordinal Theory or The Indifference Curve Analysis
(Francis Edgeworth and Vilfredo Pareto early 20th century)
This approach seeks to rank consumer satisfaction in order of preference using ordinal numbers
(number denoting position in a series). Thus under this approach, the consumer considers all
possible combinations of goods and services which he/she can afford and subsequently chooses
the combination which is most preferred. This consumer choice framework is represented by
indifference curves and the consumer budget line.
Indifference Curve (IC): - it is a locus of combinations of bundles of goods, all of which yield to
the consumer, the same levels of satisfaction. The utility along an IC is constant.

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

An Indifference Curve shows the combinations of products that yield the same satisfaction to
the consumer. Thus, a consumer is indifferent between the combinations indicated by any two
points on one indifference curve.
Quantity of clothing per week

Quantity of food per week

The indifference curve shows combinations of food and clothing that yield equal satisfaction and
among which the consumer is indifferent. (Page 89 Lipsey & Crystal).
For simplicity, the curve assumes that the consumer only consumes two goods. At point A, 5
units of food and 30 units of clothing is consumed per week. At point B, 20 units of food and 10
units of clothing is consumed per week. The same level of satisfaction is achieved at point A and
B. Thus, the consumer would have the same preference for either combination A or combination
B. In other words, the consumer is indifferent towards all consumption bundles along the
indifference curve as each gives the same level of satisfaction.
The Indifference Map
Good Y

Good X

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

A set of indifference curves is called an indifference map. The further the curve from the origin,
the higher the level of satisfaction it represents. For instance, the amount of satisfaction derived
from a consumption bundle on I3 would be greater than the satisfaction generated from a
consumption bundle on I1.
Properties of Indifference Curves

Each indifference curve shows different consumption bundles which give the same level
of satisfaction to an individual consumer.

The infinite range of indifference curves on the same set of axes is known as an
indifference map where each curve to the right shows consumption bundles which are
preferred by the consumer.

An indifference curve slopes downward from left to right i.e. it has a negative slope. The
slope measures the marginal rate of substitution which is the rate at which the consumer
is willing to substitute good X for good Y so as to leave satisfaction unchanged. (The
amount of Y the consumer is prepared to sacrifice for one more unit of X while neither
being better off or worse off by the trade.)

The curves are convex to the origin.

Indifference curves do not intersect.

The Budget Line

The budget line shows all the combinations of two goods that can be bought with a given income
and at the prices of the two goods.

Good Y

Combination

Quantity of Good X

Quantity of Good Y

25

10

20

20

15

30

10

40

50

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

25A
20

15

10

F
10

20

30

40

Good X

50

The table shows how a consumer spends an income of $5000 on two goods X and Y. The price of
good X is $100 and the price of good Y is $200.
The slope of the line gives the ratio of prices of the two goods, which depicts the rate at which
the consumer is able to substitute good X for good Y.
Slope = Y/X = 5/10 = 0.5
This shows that the price of good X is half the price of good Y.
Any point which lies within the budget line such as point P, shows consumption bundles which
are affordable but would not exhaust or use up all of the consumers income.
Good Y

BL0
Good X

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Given that the budget line is defined by the consumers income level and the prices of both Good
X and Good Y, then changes in any of these variables would lead to a change in the budget line.
An increase in income shifts the entire budget line to the right, as more of both goods can be
afforded as shown below.
Good Y

BL0

BL1

Good X

Similarly a fall in income will cause the budget line to shift to the left, indicating that only a
smaller amount of both goods can now be afforded.
Good Y

BL1

BL0
Good X

If the price of good X increases, with the price of good Y fixed, then the budget line would pivot
to the left as shown below. The consumer will now be able to afford less of good X.

Good Y

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

25

BL1

BL0
25

50

Good X

If the price of good Y decreased, this would cause an upward pivot of the budget line. The
consumer would now be able to afford more of good Y.

Good Y
50

25

Good X
50