Demand

Understanding Rational Behaviour

In economics, rational behaviour refers to the idea that individuals and firms make decisions aimed at maximising their benefits. Consumers aim to maximise utility (satisfaction), while firms seek to maximise profits. This assumption underpins many economic models and theories.

Key Assumptions of Rational Behaviour

Complete Information - Rational decision-making assumes that consumers and firms have access to all relevant information about prices, quality, and availability of goods and services. In reality, information asymmetry can lead to suboptimal decisions.

Utility Maximisation - Consumers are assumed to make choices that provide them with the highest level of satisfaction, given their budget constraints. This aligns with the concept of marginal utility, where individuals compare the additional benefit of consuming one more unit of a good versus its cost.

Profit Maximisation by Firms - Firms are assumed to make decisions that maximise their profits, such as setting optimal prices and production levels based on cost structures and market demand.

Rational Calculation of Costs and Benefits - Economic agents are expected to weigh the costs and benefits of each decision logically and consistently. This forms the basis of cost-benefit analysis, used in business and policy-making.

Consistent Preferences - It is assumed that individuals have stable and transitive preferences. This means if a person prefers A over B and B over C, they will also prefer A over C.

Law of Demand

The following video will discuss the general law of demand. This law shows the relationship between Price and the quantity of a good consumers will demand. It is important to remember that the demand curve or "function" represents the entire market demand from all consumers in that market.

Demand P1.mp4

Understanding the Assumptions behind the Law of Demand - Marginal Utility

How do we determine the value of something?

Think about a particular item you bought recently. What made you decide to buy that and not buy another item? Usefulness? Necessity?

In Economics we use the idea of Utility or the satisfaction one gets from consuming one unit of a good or service. Think back to that recent purchase you made. You did this in order to get some satisfaction from the good. We measure this satisfaction through a measure called Utils. (In reality it is difficult to actually measure satisfaction but understanding this can help us understand consumers behaviour and decisions).

Imagine you were late waking up so you ran to classes and forgot to eat breakfast. You then go for lessons and eventually lunch time arrives and you decide to go to your favourite pizza restaurant. You order your first slice of pizza. How much satisfaction do you think you will receive from this slice? Given you haven't eaten all day probably a lot. You order a second piece. Will the second piece give you the same satisfaction as the first? Whilst you might get some satisfaction, it would probably be less than the first. What about the third, fourth and fifth piece? And the tenth piece of pizza?

The amount of satisfaction will fall the more of something you consume. Lets look at this with some data.

Slice Marginal Utility Total Utility

1 10 10

2 8 18

3 6 24

4 4 28

5 2 30

6 0 30

7 -2 28

In the above situation, we can see that with each additional slice of pizza, the consumer experiences less additional satisfaction for each slice. Marginal Utility decreases. At the same time, the Total Utility increases but increases at a slower rate and after a certain point begins to decrease (after 6 slices.) This is the law of diminishing marginal utility. In this situation the additional satisfaction (utils) decreases with each additional slice of pizza until piece 6. Here consuming piece 6 adds no additional satisfaction compared to piece 5. After this point, consuming more pizza causes negative satisfaction and a lower Total Utility than the previous piece. This is called the Saturation point.

We can see in the above graph the Law of Diminishing Utility. In the above situation, a rational consumer would consume 5 pieces of pizza in order to maximise their own interests and satisfaction. This situation can clearly help us understand at what point will a rational consumer stop consuming the good. However, how do consumers chose between whether to purchase pizza or a sandwich? In order to understand this situation we need to look at utility again but this time, the amount for each good.

Item Price($) Utility per Unit Utility per $ spent

Pizza (per slice) 4 10 2.5

Chips (per bag) 2 2 1

Subway Sub (per 6 inch) 4 20 5

In this above situation, a rational decision maker would consume a Subway sub instead of pizza as the utility per $ spent is higher. Whilst, this may be true in theory, in reality we may be less "rational" and consume goods that may give us less satisfaction. We will look at this later on in Market Failures. The key thing to take from this is the idea of utility and the law of diminishing marginal utility, that is, the more of something we consume, the less additional satisfaction we receive from that additional unit.

Utils and Law of Demand

Classical economists argue the idea of individual Utility is important to help us understand the wider markets demand curve. Lets look again at a Demand Curve for pizza.

Consumers are willing and able to purchase more slices of pizza but for a lower price. This is because the marginal benefit (utils) received for each unit is less (due to the law of diminishing utility) and therefore consumers are willing to pay a lower price for a higher quantity. Therefore, the market demand curve is derived from individuals demand curves and so the demand schedule helps us understand the quantity of consumers whose are willing to consume at every given price level and this choice is given based upon maximising their own satisfaction and utility. Therefore, when we consider the market equilibrium, this represents all of those consumers who value the good at the market price or higher can consume the good. Hence, from the classical view, this helps answer the question, whom to produce for?

Non Price Determinants of Demand

This video will discuss what factors can cause an increase or decrease in the levels of Demand for a good. These factors are what will shift the curve to the right (increase in demand) or to the left (decrease in demand). It is important to remember these factors (that we call non price determinants) as these are the cause of an increase or decrease in demand.

Changes in Consumer income
Changes in Tastes and Preferences
Consumer preferences and tastes
Price of related goods (substitutes and complements)
Positive or Negative Advertisement
Changes in Demographics (age, gender, family size)
Future expectations

Demand P2.mp4

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