By Mr. LAU san-fatCH3-Consumer's Demand(1)1 HKALE Microeconomics Chapter 3: Consumer Demand(1)-The...

By Mr. LAU san-fat CH3-Consumer's Demand(1) 1

HKALE Microeconomics Chapter 3: Consumer Demand(1)-

The MUV Approach and Exchange


Six Basic Postulates1. Each individual desires more goods

and has many goals.2. For each individual, some goods are

scare.3. Postulate of substitution: economic

goods are substitutable, i.e. each person is willing to forsake some of a good to get more of other goods.


Six Basic Postulates4. Postulate of diminishing MUV: the m

ore of a good one has, the larger the TUV, but the lower the MUV of a unit.

5. Not all individuals have identical tastes and preferences.

6. Individuals are innovative but logically consistent in making choice.


Use Value and Exchange Value Value can be referred to use value or

exchange/market value. (Personal) use value (or value in use) of a

unit of a good is defined as the maximum amount of another good which a person is willing to forgo in order to obtain it.

Exchange value (or value in exchange) is defined as the amount of some other goods or money that a consumer has to pay for a given amount of a good in the market.


Use Value Vs. Exchange Value

The use value of a good is the maximum amount of other good one is willing to give up for obtaining that good.

The exchange value of a good is, however, the amount of other good to be exchanged within a transaction.



Use value is subjective. However, exchange value is an

objective concept because it can be measured, e.g. an apple can be exchanged with two lemons in a transaction.



The use value of a good depends on how people evaluate the good(i.e. individual preference) or is positively related to the number of its uses.

However, the exchange value of a good depends on the demand for and the supply of the good, i.e. depending on the degree of scarcity.



The use value of a good may be measured by the amount of money one is willing to sacrifice.

The exchange value of a good, however, if measured in terms of money, is called money price; if measured in terms of other good, it is called relative price.



Paradox of value: the use value of a good may not be in proportion to its exchange rate.

Example: water has high use value but low exchange value, while diamond has low use value but high exchange value.


Value Vs. Cost: Differences Value is the max. amount of other

good one is willing to forgo for obtaining a good.

Cost is the value of the highest-valued option forgone in making a decision.


Value Vs. Cost: Differences Value is a reflection of an

individual's preference. Cost, however, as an ex-ante

concept, is a constraint of behavior.


Value Vs. Cost: Differences The value of a free good may be

positive while the cost of a free good, however, is zero.

Value arises when people make personal valuation while cost arises because of scarcity.


Value Vs. Cost: Similarities They are measured in terms of

other goods. They are expressed in terms of

'maximum' amount of other good. They can affect decision-making.


Value Vs. Cost Cost and value are not necessarily

related. In fact, cost and value are used to derive the decision-making process of individuals.

Example: a hair cut poorer than anticipated only reduces its value, but it does not raise its cost. The cost of the hair cut will rise if the time involved in getting it done, increases in value.


Cost Vs. Price Cost is the highest-valued option

forgone while price is the physical exchange rate of one good for another good.

Cost arises because of scarcity, no choice hence results in no cost. However, price arises because of exchange, no exchange hence leads to no price.


Cost Vs. Price Cost still exists in an one-man

economy while price is absent in one-man economy because of no interpersonal exchange.


TUV, AUV & MUV Total use value (TUV) is the maximum tota

l amount of another good that one is willing to pay for the entire quantity of a good.

Average use value (AUV) is the total use value divided by the number of units (Q) of a good, i.e. TUV/Q

Marginal use value (MUV) is the maximum amount of another good that a person is willing to pay for an extra unit of a good. MUV=TUV/Q=slope of TUV curve.


TUV, AUV & MUV: IllustrationQ(1) MUV(2)

= (4)/ (1)AUV(3)=(4)/(1)

TUV(4)=(2)

1 $10 $10.0 $102 $9 $9.5 $193 $8 $9.0 $274 $7 $8.5 $345 $6 $8.0 $406 $5 $7.5 $457 $4 $7.0 $498 $3 $6.5 $529 $2 $6.0 $54

10 $1 $5.5 $55


TUV, AUV & MUV: Diagrams

Use Value

0 Q

TUV

MUV AUV


The Marginal Use Value Curve A MUV curve slopes downward indicating

that as one's holdings of a good get larger, there is a decrease in one's marginal personal value for that good.

The position or height of the whole curve varies positively with the wealth (or number of other goods) a person has: it shifts upward for superior goods and downward for inferior goods.

With different tastes or preferences, the MUV curves are not identical for everyone.


Price, MUV & Consumer's Equilibrium In making consumption, individuals will

compare its cost (P) with expected benefits (MUV) of a good.

If MUV>P, it is beneficial to buy and thus bringing down MUV until decreasing MUV=P.

If, however, MUV<P, one will reduce his quantity demanded for avoiding loss, which brings up MUV until increasing MUV=P.

Hence, consumer's equilibrium is attained when P=MUV (for the last/marginal unit transacted).


Demand Curve and MUV Curve A consumer's MUV curve of a good can

be regarded as an ordinary individual demand curve for that good because: given the MUV curve, one maximizes his

gain by equating his MUV with the market price.

it tells how many units one consumes given any level of market prices.


Price, Total Revenue, Average Revenue & Marginal Revenue Total revenue, TR=PXQ Average revenue

AR=TR/Q Then, AR=(PXQ)/Q Thus, AR=P

Marginal revenue, MR=TR/Q


Demand Curve & Average Revenue (AR) Curve Demand curve reflects relationship be

tween P & Qd while AR curve reflects AR & Qd(=Qs=Qt at equilibrium).

As P=MUV and P=AR, P=AR=MUV Hence, AR curve=D curve=MUV curve


P, TR, AR & MR: IllustrationP(1) Q(2) TR(3)

=(1)x(2)AR

=(3)/(2)MR

=(3)/(2)

10 1 10 10 109 2 18 9 8

8 3 24 8 6

7 4 28 7 4

6 5 30 6 2

5 6 30 5 0

4 7 28 4 -2

3 8 24 3 -4

2 9 18 2 -6

1 10 10 1 -8


TR, AR & MR: Diagrams

TR

TR

0 Q

AR, MR

0 QMR AR



TR

TR

0 Q

AR, MR

0 QMR AR

TR reaches its maximum when MR=0.



TR

TR

0 Q

AR, MR

0 QMR AR


TR rises when MR is positive



TR

TR

0 Q

AR, MR

0 QMR AR


TR rises when MR rises

TR falls when MR falls


Finding TR from AR Curve TR=rectangular area defined by

drawing perpendicular lines from a particular price and the corresponding quantity to the demand/AR curve.P

0 Q1 Q

AR

TRP1


Finding TR from MR Curve TR=the area under the MR curve

and above the quantity axis.

P, AR, MR

0 1 2 3 4 Q

AR

P1

MR

MR1 for 1st unit

sold


Finding TR from MR Curve TR=the area under the MR curve

and above the quantity axis.

P, AR, MR

0 4 Q

AR

TR

P1

MR

Summation of MR for 4 units sold


Finding MR from TR Curve MR=slope of the TR curve=TR/

Q.P, AR, MR, TR

0 Q1 Q

TRTR1

E

Slope of TR curve = MR

TR

Q


Finding AR from TR curve AR=TR/Q=slope of a ray from the

origin to a point on TR, say point E.P, AR,MR, TR

0 Q1 Q

TRTR1

ESlope of the ray = AR

A ray from the origin to point E

TR at point E

Q at point E


Why is Price Larger Than MR? Because a cut in price is made to sell more

units, the extra revenue will be less than the price received on the extra unit sold.

However, the new uniform price at which an extra unit is sold is lower on ALL the units formerly sold at the higher price.

Reduction in revenue on the quantity previously sold at the higher price will offset part of (or possibly more than) the price received on the extra unit sold.


Why is Price Larger Than MR? Thus, the net revenue increase or MR

from selling one more at the new, lower price will always be less than the price received on that extra unit – less by the amount of reduced revenue on all the units formerly salable at the old, higher price.

With different pricing tactics, say price discrimination, MR could be equal to P.

MR =P2(Q2-Q1)-(P1-P2)Q1


Relations Between TR, AR & MR MR is less than AR(or P)

P, AR, MR

P1=$10P2=$9

0 Q1 Q2 Q 1 2

D=AR

Loss in TR

Gain in TR MR from selling 2nd unit

P Q MR

10 1 109 2 8


Relations Between TR, AR & MR MR is less than AR(or P) P Q M

R

10 1 109 2 8

P, AR, MR

P1=$10P2=$9 $8

0 Q1 Q2 Q

D=AR

Loss in TR

Part of the TR from selling 2nd unit will be taken away as a compensation for loss in revenue of the previous unit(s) under uniform pricing.

MR = P2(Q2-Q1) -(P1-P2)Q1

MR of 2nd unit sold


Relations Between TR, AR & MR MR is less than AR(or P): an

illustrationP Q TR AR MR=P2(Q2-Q1)-(P1-P2)Q1

10 1 10 10 /

9 2 18 9 9(2-1)-(10-9)1=88 3 24 8 8(3-2)-(9-8)2=67 4 28 7 7(4-3)-(8-7)3=46 5 30 6 6(5-4)-(7-6)4=25 6 30 5 5(6-5)-(6-5)5=0


Relations Between TR, AR & MR The slope of MR curve is twice the

slope of AR curve.Remarks:Point A=mid-point of AR curveArea BCP1=area ACQ1

P, AR, MR

P1

0Q1

D=AR

MR

AC

B


TEV, AEV & MEV (Total)Exchange value (TEV) of a

specified quantity of a good is the actual amount of money(or some other goods) that one has to pay for that entire specific quantity. TEV=PXQ TEV=Total revenue(TR)=Total

expenditure(TE) =Total market value(TMV)


TEV, AEV & MEV Average exchange value(AEV) of a specified

quantity of a good is the average revenue received by the seller, i.e. AEV=AR=TEV/Q.

Marginal exchange value(MEV) is the actual amount of money or some other goods one pays for an extra unit of the good, i.e. MEV=TEV/Q.

Under uniform pricing/single per-unit pricing arrangement, price refers to AEV or AR.


Consumer's Surplus (CS) CS is the extra amount the consumer i

s willing to pay over and above what he or she actually pays, given quantity demanded. CS=TUV-TEV for a given quantity CS=MUV-P for an extra unit

It is assumed that the CS is calculated under uniform pricing (or single per-unit pricing).


Consumer's Surplus (CS)P, MUV

P1

D=MUV

0 Q

CS

TEV

A

B

Q1

Remarks:•Area 0ABQ1=TUV•Area 0P1BQ1=TEV•CS=TUV-TEV =area 0ABQ1-area 0P1BQ1 =area ABP1


Consumer's Surplus (CS): An IllustrationP(1)

=MUVQ(2) TEV(3)

=(1)X(2)TUV(4)=(1)

CS(5)=(4)-(3)

10 1 10 10 0

9 2 18 19 1

8 3 24 27 3

7 4 28 34 6

6 5 30 40 105 6 30 45 154 7 28 49 213 8 24 52 282 9 18 54 361 10 10 55 45


Paradox of Value Adam Smith pointed out in his book,

'The Wealth of Nations', that the things (e.g. water) which have the greatest value in use frequently have little or no value in exchange and those (e.g. diamond) which have the greatest value in exchange frequently have little value in use.


Resolving The Paradox of Value The paradox arises from confusing total and ma

rginal use values with market values. The exchange value of a good is determined by

its relative scarcity and its MUV, but not its TUV. The more scarce the good, the higher its MUV w

ill be, thus demanding a higher price(or average exchange value); vice versa.

While a good with higher TUV would bring a larger consumer's surplus and thus more benefit.


Resolving The Paradox of Value

P, MUV

P

D=MUV

0 Q

CS

TEV

Q

P, MUV

P

D=MUV

0 Q

CS

TEV

Q

S S

Diamond Water


Ways to Extract Consumer's Surplus(1) By all-or-nothing pricing tactic

Consumers either purchase a good at a stipulated quantity at a given price, or not at all.

The price under an all-or-nothing arrangement is set in accordance with the AUV of the last unit, i.e. P=AUV.

As the TUV of the good becomes the same as its TEV, CS is then fully exploited.


Ways to Extract Consumer's Surplus(1) By all-or-nothing pricing (AONP)

tacticP, MUV, AUV

P2=AUV

Ordinary D=MUV0 Q

A

B

Q1 Q2

All-or-nothing D=AUVP1=MUV

C

E

Remarks:TEV=P2XQ2=area 0P2BQ2TUV=area 0AEQ2


Ways to Extract Consumer's Surplus(1) By all-or-nothing pricing (AONP)

tactic Remarks: Under uniform pricing, consumer buys Q2 at P1(=MUV); however, under AONP,he has to pay P2(=AUV) for Q2, or not at all. Thus, as area ACP2=area BCE, TUV=TEV & CS=0.

P, MUV, AUV

P2=AUV

Ordinary D=MUV0 Q

A

B

Q1 Q2

All-or-nothing D=AUVP1=MUV

C

E


Ways to Extract Consumer's Surplus(2) By charging price with fees, e.g. mem

bership fees or license fees, where the fee is set to extract all of the consumer's surplus.

P, MUV

P1MUV

0 Q1 Q

Membership or license fee = CS

Remark:TEV=area 0P1EQ1 + area P1AETUV=area 0AEQ1As TEV=TUV, CS=0

A

E


Ways to Extract Consumer's Surplus(3) By practicing 1st degree price

discrimination: charging the maximum amount the consumer is willing to pay for EACH unit, then P=MUV.

P, MUV

MUV

0 1 2 3 4(Q1) Q

Remark:TUV=area 0AEQ1TEV=area 0AEQ1As TUV=TEV, CS=0

A

EP1P2P3P4


Why does Exchange Occur? It is commonly, but wrongly, believed

that people trade because they have a surplus of some goods.

In fact, trade or exchange occurs because participants find it mutually beneficial, because people place different marginal valuations on scarce goods.


Assumptions behind the Simple Exchange Model1. Private property rights exist.2. Transaction costs are zero.3. There is no production taken place, i.

e. the stock of any good is fixed.


Conditions for Conducting Mutually Beneficial Exchange Trade occurs when participants have

different marginal use value curves, even though they have the same initial endowment of a good.

Trade is still possible even trading parties have the same MUV curves, if their initial endowments are different.


Exchange without Production The individual with higher MUV will be

the buyer while the one with lower MUV will act as the seller.

The seller is willing to engage an exchange if the price he receives is higher than or equal to the forgone MUV.

The buyer, however, will buy a unit only if what he actually pays (P) is lower than or equal to what he receives(MUV).


Exchange without Production The actual trading price then lies bet

ween the different initial MUVs of the traders.

The equilibrium price is indicated at where the two MUV curves intersect.

Exchange brings the MUVs of a good to both parties to equality, and no further trade would be mutually desired.


Exchange without Production Gains from exchange to the buyer:

Per unit gain = MUV – P Total gain = TUV – TEV

Gains from exchange to the seller: Per unit gain = P – MUV forgone Total gain = TEV – TUV forgone

However, the distribution of gains from exchange depends on the bargaining power or pricing tactics of both trading parties.


Exchange without Production If the buyer has higher bargaining power,

he will enjoy most or all of the gains from trade by obtaining the lowest possible price.

If, however, the seller has higher bargaining power, he will capture most or all of the gains from trade by requesting the highest possible price.

As with normal shaped MUV curves, both parties share the gains from trade.


Exchange without Production: An Illustration


Transaction Costs & Exchange There are substantial costs of finding trade pos

sibilities, or assessing the true characteristics or qualities of goods, and of negotiating exchange contracts and arranging for such legal protections as warranties.

With the presence of transaction costs, the gain from trade to traders are thus reduced.

As a maximizer, traders will seek ways to reduce transaction costs and maximize their gains from trade. And this could be done by employing middlemen and using money.


Exchange with Transaction Costs and without MiddlemenRemarks: Let transaction costs be $1.5, of which $0.5 is borne by seller while $1 by buyer.

Loss to buyer as her full price increases.

Loss to seller as his net realized selling price falls.


Exchange with Transaction Costs and MiddlemenRemarks: Let middlemen costs be $0.75, of which $0.5 is borne by buyer while $0.25 by seller.


Exchange with Transaction Costs and Middlemen Whenever the fees charged by middlemen for

arranging and facilitating an exchange is lower than the transaction costs being borne by traders in conducting prepurchase search and production inspection, trade is still beneficial.

In an open market, competition among middlemen reduces the spread between their buying and selling prices to one that just covers the costs of providing their services at the quality wanted by the consumers.

By Mr. LAU san-fatCH3-Consumer's Demand(1)1 HKALE Microeconomics Chapter 3: Consumer Demand(1)-The...

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