Economics “Ask the Instructor” Clip 75 Transcript
Why do consumers typically buy less of an item when its price rises?
This sounds like a simple question, but there is more to it than you might initially think. This question really asks for rationale behind the law of demand, which is arguably the most important behavioral proposition in all of social science.
First of all, recall that the law of demand applies only when other things do not change. This is what is meant by ceteris paribus. The prices of all other goods are included in the ceteris paribus assumption. Thus, the law of demand predicts how consumers react to a change in relative price. For example, we would not predict that consumers would buy less of Good X if its price rose proportionately with the prices of all other goods and with the prices of all factors of production. Remember that we’re talking about relative, not absolute, price changes.
Suppose that you and some friends enjoy pizza and hot-wings. Assume that the price of a slice of pizza is 1 dollar and the price of wings is 50 cents each. On this particular day, let’s assume that the last slice of pizza gives you twice the utils as the last wing consumed. So the marginal utility of the last unit consumed of each good relative to its price is the same; you are in equilibrium. Recall that utility is not measurable so the util is just our fictitious measure of utility.
Later in the week, suppose that you and your friends are in the same restaurant, but now you notice that the price of wings has doubled to 1 dollar each. How would you react? We are assuming that there has been no change in your preferences or your income.
At the margin, you now get half the utils per dollar from wings as before. Why? Because the price of wings has doubled. You would no longer be in equilibrium by eating the same combination of wings and pizza as before. Utility per dollar spent on wings is now less than utility per dollar spent on pizza. Total utility is maximized, for a given expenditure, only if marginal utility per dollar is equal across all goods consumed. What would you, a rational consumer, do?
You would increase your consumption of pizza and reduce your consumption of wings. Why? Because at the new set of relative prices, you now get more utility per dollar spent on pizza than you get from wings. As you adjust your consumption pattern, the marginal utility derived from the last slice of pizza falls because of the law of diminishing marginal utility whereas the marginal utility of the last wing rises. Remember, you have reduced your consumption of wings.
A new equilibrium will be established, the point is that you now buy fewer wings because the price of wings has risen relative to the price of pizza. You must take this adjustment in order to get the most total utility from a given expenditure. But notice that this line of thinking leads us to a necessary inverse relationship between price and quantity consumed.
The idea of marginal utility and the desire to maximize total utility are often used to explain why demand curves slope downward.