Demand Theory, Part I

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AGEC/FNR 406
LECTURE 4
Collecting fragments of coal in a rail yard in
China
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Theory of Consumer Demand

• Lecture Goals

1. Briefly review of demand theory
2. Discuss features of demand curves.
3. Identify importance of these concepts for
environmental and resource economics.
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Utility
Utility value (not necessarily in terms)

• Because resources provide utility, individuals
  want them.

Four basic laws of demand 1. Consumers prefer
more to less 2. Value rises at a decreasing
rate 3. Consumers aim to balance consumption 4.
Consumers face budget constraints
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• Example utility from coal

utility
60 50 40 30 20 10 0
Utility is increasing at a decreasing rate
0 1 2 3 4 5 6 7
Units of coal
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• Indifference curve two forms of recreation

Ski trips
At all points along the indifference curve, an
individual is indifferent about receiving the
corresponding bundles of goods.
Beach trips
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• Indifference curve two forms of recreation

Ski trips
Individuals substitute
Beach trips
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• Indifference curve two forms of recreation

Ski trips
Utility is increasingmore is better
Beach trips
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• Utility MaximizationTwo part processPart 1

Ski trips

Income PSKI
Budget ConstraintAt all points along the
budget constraint, an individuals incomeis
completely exhausted.

0 0
Income PBEACH
Beach trips
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• Utility MaximizationTwo part processPart 2

Ski trips

Income PSKI
Tangency Tangency of budget constraint with
the indifference curve identifies the point of
optimal consumption for the individual. This
corresponds to a single point (price-quantity
combination) on the demand curve.

skitrips
beach
trips

0 0
Income PBEACH
Beach trips
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Points to ponder 1

• The fact that utility is increasing at a
  decreasing rate means that the first few units of
  an environmental improvement will have a larger
  impact on individuals (and society) than
  subsequent improvements. Examples clean
  water, clean air, national parks, reductions
  in pesticide residue or pesticide exposure.

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Points to ponder 2

• The mixture of environmental quality and
  consumer goods that we observe is the result of a
  lot of individual decisions about what tradeoffs
  are acceptable.

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Points to ponder 3

• Consumers prefer more to less, but have finite
  resources and are forced to make tradeoffs.
  This pattern is also repeated at the level of
  society.

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Points to ponder 4

• The budget constraint depends onboth income and
  prices. When prices change, this will cause a
  shift in patterns of consumption due to income
  and substitution effects.

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Points to ponder 5

• Higher incomes mean we can enjoy more
  environmental improvements, if we choose
  to.Poor individuals and poor countries are
  generally more sensitive to the tradeoffs that
  environmental improvements require.

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