Deriving the Demand Curve: What is Budget constraint : The marginal rate of substitution Meanings : Graphical Representation Of Demand

 The consumers will tend to consume a combination of products such that the marginal utility per dollar spent on each product is the same. The slope of the budget constraint called the price ratio is the price of the product on the horizontal axis divided by the price of the product. On the vertical axis the price ratio describes the rate in which one can trade off beer for pizza and keep total expense constant.

 For example suppose price of beer is $1 in the price of a slice of pizza is $2 the price ratio is the price of Pizza divided by the price of beer or 2/1 or 2. A price ratio of 2 means that you could exchange two beers for one pizza and your total expense would not change.

 For example suppose you have 10 beers and 10 pizzas your total expenses 30 dollars. If you exchange two beers for one Pizza you're left with eight beers and 11 pizzas your total expenses now eight beers times $1 plus 11 pizzas times two dollars a pizza or $30. As long as you exchange beer for pizza in the ratio of two to one your total expense doesn't change. The absolute value of the slope of the indifference curve called the marginal rate of substitution is the marginal utility of the product. On the horizontal axis divided by the marginal utility of the product and the vertical axis the marginal rate of substitution describes the rate in which you can trade off beer for pizza and keep your utility constant. For example suppose your utility is the units of Pizza you consumed multiplied by the units of beer you consume. If you have ten beers and five pizzas your total utility is 50 your marginal utility of beer is five.

 If you consume one more beer your utility rises by five from 50 to 55. Your marginal utility pizzas 10 if you consume one more Pizza your utility rises by 10 from 50 to 60 your marginal rate of substitution is ten divided by five or two if you exchange beer for pizza in the ratio of two to one your utility will remain constant. Note that the slope of the indifference curve the marginal rate of substitution is large on the left side of the graph and small on the right side of the graph. Bundle A represents three pizzas and twelve beers the marginal rate of substitution at Point A is four this means that in order to keep your utility constant you would have to gain four beers for every one pizza you lost. Why would you have to gain so many beers just for losing one pizza. At bundle A You're consuming a lot of beer and only a little pizza we know that the more beer you consume the lower is your marginal utility of beer. 

At bundle A You are consuming a lot of beer so the marginal utility you receive from one more beers low. But you're also consuming little pizza so the marginal utility you receive from one more pizza is high and the marginal utility you lose from consuming one fewer pizzas is high. Because you're consuming so much beer in so little pizza the amount of utility you gain from consuming one more beer is far less than the utility you lose from consuming one less slice of pizza. So in order to maintain a constant utility you're gonna have to receive more than one beer in exchange for losing one slice of pizza bundle. B represents three beers and twelve slices of pizza the marginal rate of substitution here is one-fourth this means that in order to keep your utility constant you would have to gain one-fourth of a beer for every one slice of pizza you lost. Because you're consuming so little beer and so much pizza the utility you lose from consuming one less beer far exceeds the utility you gain from consuming one more pizza. So in order to maintain a constant utility you need only gain a fraction of a beer in exchange for losing one slice of pizza. Suppose you have 18 dollars to spend on beer and pizza let's superimpose several of your indifference curves on your budget constraint you are capable of purchasing any combination of beer and pizza along the budget constraint. How much beer and pizza will you purchase look at consumption bundles A and M you are indifferent between A.M. Because they both appear on the same indifference curve both combinations yield a utility of 10 and you're capable of purchasing either combination. Because they both appear on the budget constraint will you choose either one of these two combinations of beer and pizza.

 The answer's no combinations B and L costs the same amount of money as a AM  all four on the budget constraint but B and L yield more utility than A and M, because B and L are on a higher indifference curve than A.M. But wait bundles C and K both cost the same as B and L but are on a higher indifference curve still notice that bundle G costs the same as all of the other bundles, but as on the highest attainable and difference curve given your desires as depicted by the indifference curves and your capabilities as depicted by the budget constraint. You will consume the combination of beer and pizza in bundle G now let's clean up this picture by removing the extraneous indifference curves given your budget constraint. The highest utility you can obtain is 14 and you obtain it by consuming six beers and six slices of pizza indifference curves tell us what you would like to have? The budget constraint tells us what you're capable of having the combination of the two. Tells us what you will have suppose the prices of beer and pizza are both a dollar fifty each and that the price of Pizza falls from a dollar fifty to one dollar the decrease in the price of Pizza, causes the budget constraint to rotate to the right when the budget constraint rotates to the right. You can now attain a higher utility before as before you will choose the combination of beer and pizza that is on the highest attainable indifference curve. In this example it is seven point two beers and seven point two slices of pizza notice that the decrease in the price of Pizza caused you to consume more pizza. We know two things about your consumption of pizza when the price of pizza is a dollar fifty you will want to buy six units of Pizza when the price of pizza is one dollar you will want to buy seven point two units of pizza. This relationship between the price of pizza and the number of units of Pizza you want to buy is demand.

 We have found where demand comes from demand is what results when consumers attempt to maximize their utilities given their budget constraints.

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