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Study Guide (Course-wide Content)
Market demands or demand curves are explained as stemming from the process of individuals' choosing their most preferred bundle of consumption goods and services.
Economists explain consumer demand by the concept of utility, which denotes the relative satisfaction that a consumer obtains from using different commodities. The additional satisfaction obtained from consuming an additional unit of a good is given the name marginal utility, where "marginal" means the extra or incremental utility. The law of diminishing marginal utility states that as the amount of a commodity consumed increases, the marginal utility of the last unit consumed tends to decrease.
Economists assume that consumers allocate their limited incomes so as to obtain the greatest satisfaction or utility. To maximize utility, a consumer must satisfy the equimarginal principle that the marginal utilities of the last dollar spent on each and every good must be equal.
Only when the marginal utility per dollar is equal for apples, bacon, coffee, and everything else will the consumer attain the greatest satisfaction from a limited dollar income. But be careful to note that the marginal utility of a $50-per-ounce bottle of perfume is not equal to the marginal utility of a 50-cent glass of cola. Rather, their marginal utilities divided by price per unit are all equal in the consumer's optimal allocation. That is, their marginal utilities per last dollar, MU/P, are equalized.
Equal marginal utility or benefit per unit of resource is a fundamental rule of choice. Take any scarce resource, such as time. If you want to maximize the value or utility of that resource, make sure that the marginal benefit per unit of the resource is equalized in all uses.
The market demand curve for all consumers is derived by adding horizontally the separate demand curves of each consumer. A demand curve can shift for many reasons. For example, a rise in income will normally shift DD rightward, thus increasing demand; a rise in the price of a substitute good (e.g., chicken for beef) will also create a similar upward shift in demand; a rise in the price of a complementary good (e.g., hamburger buns for beef) will in turn cause the DD curve to shift downward and leftward. Still other factors—changing tastes, population, or expectations—can affect demand.
We can gain added insight into the factors that cause downward-sloping demand by separating the effect of a price rise into substitution and income effects. (a) The substitution effect occurs when a higher price leads to substitution of other goods to meet satisfactions; (b) the income effect means that a price increase lowers real income and thereby reduces the desired consumption of most commodities. For most goods, substitution and income effects of a price increase reinforce one another and lead to the law of downward-sloping demand. We measure the quantitative responsiveness of demand to income by the income elasticity, which is the percentage change in quantity demanded divided by the percentage change in income.
Remember that it is the tail of marginal utility that wags the market dog of prices. This point is emphasized by the concept of consumer surplus. We pay the same price for the last quart of milk as for the first. But, because of the law of diminishing marginal utility, marginal utilities of earlier units are greater than that of the last unit. This means that we would have been willing to pay more than the market price for each of the earlier units. The excess of total value over market value is called consumer surplus. Consumer surplus reflects the benefit we gain from being able to buy all units at the same low price. In simplified cases, we can measure consumer surplus as the area between the demand curve and the price line. It is a concept relevant for many public decisions—such as deciding when the community should incur the heavy expenses of a road or bridge or set aside land for a wilderness area.
