A simple Model Demand Chap3 Flashcards
Consumer surplus
The difference between what a consumer actually pays for a good and the maximum they would have been willing to pay for it. In a sense it represents the ‘profi t’ to a consumer. By defi nition, if a consumer is rational, then they only purchase goods that they feel are worth more than what they have to pay for them.
Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for the product).
Inferior goods
Goods for which demand decreases as income increases.
Law of diminishing marginal utility.
A hypothesis that states that as consumption of a good increases so the marginal utility (extra benefi t gained) decreases.
Normal goods
Goods for which demand increases as income increases.
What are the 2 main reasons why it is useful to analyse the demand?
First, it can be used to help predict likely reactions and consumer behaviour. For example, if a charge is introduced for a drug or a test, what will be the effect on the number of people using that drug or test? Second, knowing something about people’s demand for health care may say something about how much they value a good. This can in turn inform policy decisions such as how much a particular good should be subsidized.
How is demand represented?
Demand = f (P, Y, Pc, Ps, T)
f (. . .) is standard mathematical notation and means ‘is a function of’
P = price of the good
The amount of a particular good that a household will want to buy is a function of the price (P) of the good.
For most goods, the higher the price, the less of that good people will want to buy; the lower the price, the more quantity is demanded
Y = income
The higher your income, the more likely it is that more of a good will be demanded at any given price. Therefore if your income falls, you might consume less paracetamol per year
Pc = price of complementary goods
Ps = price of substitute goods
T = tastes or preferences
Complement
A good that is often needed when consuming another good. For instance, sugar can be seen to be a complement to tea.
Why does there demand curve slopes downwards?
If for instance the price of coffee rises, consumption of coffee falls and the consumption of other drinks like hot chocolate or tea tends to rise. There is no reason to believe that the satisfaction consumers gain from a cup of coffee or a cup of tea has changed. However, the switch in demand occurs because the satisfaction obtained per pound (£) spent on coffee falls in relation to a pound spent on tea. Economists call this the substitution-effect – it is an attempt on the part of consumers to adjust consumption in response to a price change. This partly explains why the demand curve slopes downwards. The other important effect is the income effect. The two most important determinants of the total amount of goods you consume are your income and prices. When the price of a good rises (such as petrol), if you continue to buy the same amount as before, you will have less income available to buy other goods. So the rise in the price of petrol is similar to a fall in real income. This income effect means that you will buy less of a good when its price rises in order to have enough income available to buy other goods.
Total utility
Total utility is the total satisfaction that a person gets from the consumption of goods. Total utility depends on the person’s level of consumption – more consumption generally gives more total utility
Marginal utility
Marginal utility is the change in total utility resulting from a one-unit increase in the quantity of a good consumed. You will recall from Chapter 1 that diminishing marginal utility means that as we consume more and more of a particular good the utility obtained from each extra unit of consumption will tend to fall.
Water and diamonds: perk 2008
Water is essential to life itself while diamonds are just inessential luxuries. So water is much more valuable than diamonds. Yet the price of water is a tiny fraction of the price of a diamond. Why? This question is the paradox of value that has puzzled philosophers for centuries. Adam Smith tried but failed to solve this paradox. Not until the theory of marginal utility had been developed could anyone give a satisfactory answer. You can solve Adam Smith’s puzzle by distinguishing between total utility and marginal utility. The total utility that we get from water is enormous. But remember, the more we consume of something, the smaller is its marginal utility. We use so much water that the marginal utility – the benefi t we get from one more glass of water – diminishes to a tiny value. Diamonds, on the other hand, have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility. When an individual has maximized total utility, he or she has allocated his or her budget in the way that makes the marginal utility per pound spent equal for all goods. That is, the marginal utility from a good divided by the price of the good is equal for all goods. This equality of marginal utilities per pound spent holds true for diamonds and water. Diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility. When the high marginal utility of diamonds is divided by the high price of diamonds, the result is a number that equals the low marginal utility of water divided by the low price of water. The marginal utility per pound spent is the same for diamonds as for water.
Derived demand
For example, unlike most other goods, health care does not yield utility directly. Few people enjoy the experience of consuming health care. Its value comes from the positive effect one hopes it has on health and, in turn, the satisfaction we derive from the activities we can do when we are healthy (that is, working and leisure activities). Demand for health services is therefore a derived demand.
Can you think of other ways in which the demand for health care is different from the demand for other goods?
Derived demand
1 The demand for health care is often for a single one-off intervention rather than multiple or repeated requests as often occurs with the consumption of DVDs or soap.
2 It is generally assumed in economics that consumers are able to make informed decisions about their consumption patterns. Consumers are said to be ‘sovereign. However, in the case of health care, consumers often delegate this decision-making power to health professionals who are much better informed.
3 Patients’ perceptions of their need and of their capacity to benefi t, both of which shape their demand, may be strongly infl uenced by their doctor – the supplier of health care.
4 Another complication relates to the fact that health care is extremely heterogeneous. Every patient has a slightly different combination of ailments and symptoms, and therefore every patient needs to buy a slightly different package of care. Furthermore, individuals will vary in how they respond to treatments.
5 A major difference is that payment for many health services comes, partly or wholly, from a third party (either an insurance company or a government) which means individual users of services may not be sensitive to the price of these services.
Indifference curve
This type of analysis can be used to examine how a consumer would change the combination of two goods if there was a change in their income or a change in price. Indifference curve analysis combines two concepts: indifference curves and budget lines.
It curves inward because of the concept of the diminishing marginal rate of substitution between the two goods.
The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility. You will recall that this principle states that the more units of a good consumed the less additional satisfaction will be gained from extra units consumed. It is possible to draw more than one indifference curve on the same diagram – this is called an indifference curve map. The general rule is that indifference curves further to the right show combinations of the two goods that yield a higher utility and vice versa.
The budget line is important to the analysis of consumer behaviour. The budget line illustrates all the possible combinations of two goods that can be purchased at given prices with a set budget.
A change in income will cause a shift in the budget line but its slope will remain the same. A rise in income will cause the budget line to shift outward while a fall in income will result in an inward shift.
