# Classical microeconomic theory

We will now build on the first element and take a detailed look at demand, supply and product definitions. Firstly, an examination of the factors which influence demand and supply will enable us to understand the context of electronic markets. We will then consider the definitions of products, their subdivision into goods and services and availability on the Internet. These conventional definitions will then be applied to digital products, anything that can be stored in electronic form, which are available on the Internet. Finally, the unique characteristics of digital products will be considered.

Demand: utility theory Utility theory is a method economists use to analyse consumer demand. It works on the basis that utility, or pleasure gained from a product, can be measured. It is assumed consumers are rational. If two products are similar in all aspects apart from price, the consumer will prefer the cheaper one. If the consumer prefers attending the cinema to watching football, and attending football to ice skating, then cinema will be preferred to ice skating. The satisfaction a consumer gets from consuming a product is called utility.

Total utility is the total satisfaction from the amount consumed. For example, the total utility from 50 minutes of

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Internet usage is the total satisfaction provided by the 50 minutes. Marginal utility is the change in satisfaction from increasing consumption by one extra unit. To extend our above example, the marginal utility of the 50th minute is the difference in total utility from consuming 49 minutes and 50 minutes. Utility theory makes the assumption that consumers have diminishing marginal utility. This means that as consumption of a product increases the marginal utility diminishes.

For example, the utility from a second cup of coffee is less than that from the first cup. The following example considers the utility gained from viewing films through the Internet using video on demand (VOD). Figure 1: Total and marginal utility Total utility gained rises as more films are viewed but by a diminishing amount, as shown by the values for marginal utility. 2. 1 Maximising utility We stated the assumption earlier that consumers aim to maximise their own utility. We can now convert the marginal utility schedule shown above into the demand curve for video on demand.

To do this we need to know how much a unit of utility is worth. We do this by considering how much utility could be gained by consumption of something apart from VOD where utility would be highest. Our example will be Ten Pin Bowling (TPB) where we will say ? 1 of expenditure gives one unit of utility. We can now convert our utility values in figure 1 to ? values. This now shows the value in ? s our consumer places on each unit consumed. We next give a market price of, we will assume, ? 5 for a video-on-demand film. We can now compare the market price to the utility in ?

s our consumer places on the consumption. For a utility maximising consumer it is logical to increase consumption as long as the marginal utility gained (in ? s) is greater than the price of the product. Consumption will continue until marginal utility in ? s is equal to price. So in our example, with a price of ? 5 our consumer will see 5 films per month. For the first four films, marginal utility is greater than price and for the fifth film it is equal. The utility, total and marginal, measured in ? s are plotted in the following diagrams. 2. 2 Total utility Figure 2: Total utility 2.

3 Marginal utility Figure 3: Marginal utility The marginal utility graph shows how much a consumer will pay for additional units. So, as marginal utility falls with increased consumption consumers will only buy more if the price falls. Therefore, this is the demand curve for our consumer. Notice that whilst total utility increases, marginal utility decreases. 2. 4 Equilibrium for many products (reference only) We can develop this analysis to maximise utility for more than one product. We do this by comparing the marginal utility per unit of expenditure. This is given by the equation:

(1) MUx/Px where • MUx is the marginal utility of the last unit of product x • Px is the price of product x. So if for one product, for example video-on-demand, the marginal utility is ? 30 with a price of ? 5 we have a value of 6. If for another product, for example, ten pin bowling the marginal utility is ? 4 with a price of ? 1 we have a value of 4. Our utility maximising consumer will increase consumption of the product with the higher marginal utility per unit of expenditure, video-on-demand, at the expense of ten pin bowling, to increase their total utility.

However, this will reduce the marginal utility of VOD, as more is consumed, and raise the marginal utility of ten pin bowling, as less is consumed. Eventually, the marginal utilities will change sufficiently so that the marginal utility of ? 1 spent on video-on-demand equals the marginal utility of ? 1 spent on ten pin bowling. In this situation total utility is maximised and cannot be increased by changing consumption patterns. We can summarise the condition for maximising total utility, for our above example, as follows: (2) MUvod/Pvod = MUtpb/Ptpb • MUvod is the marginal utility of the last unit of video-on-demand

• MUtpb is the marginal utility of the last unit of ten pin bowling • Pvod is the price of video-on-demand • Ptpb is the price of ten pin bowling 2. 5 Deriving demand curves (reference only) Our look at utility theory now enables us to derive the demand curve for most products. We can rearrange our earlier equation, equation 2 (2) MUx/Px =MUy/Py to give (3) MUx/MUy =Px/Py The right hand side of the equation looks at the relative prices of the products. This is beyond the control of a consumer. The left hand side, however, is decided by the consumer and how they adjust their consumption.

Therefore, if the two sides of equation 3 are not equal, our consumer can balance them by adjusting purchases. For example, if the price of video-on-demand increases by ? 2 per film the right hand side of our equation is greater than the left hand side. To restore balance to the equation the marginal utility of video-on-demand must be increased, which involves reducing its consumption. The same result could also be achieved by reducing the marginal utility of ten pin bowling by increasing its consumption, or by adjusting the consumption of both to balance the equation.

If we let y stand for all other products we are able to state the basic law of demand, which we will do in the next section. It should be noted utility theory has been subject to criticisms. The main criticism is that it cannot be measured. However, the principles of total utility and diminishing utility are still a powerful conceptual framework. 3 The demand schedule An increase in the price of a product, with income and other prices kept constant, will lead to a decrease in the quantity demanded. Conversely, a reduction in price will lead to an increase in demand. This gives us the following demand curve.

Figure 4: The demand schedule So in the above example when price is set to P1 the quantity demanded is Q1. However, when price is increased to P2 the quantity demanded falls to Q2. This comes from substitution to other products and from consumers decreasing their consumption. In terms of our earlier equation as the price increases the marginal utility per pound or unit of currency decreases, thus making consumption less attractive. It is important to remember here that this is effective demand as it is only the consumers, who have the ability to pay, who consume at any given price.

There is also an income effect at work here. If the price is increased consumers real income falls, making consumers poorer, thus reducing the amount they have to spend on the product. 3. 1 Substitutes Substitutes exist when a product is seen as a direct replacement for another product. For example, in the Internet context examples of close substitutes are Schwab for DLJ in share trading, lastminute for QXL in Business to Consumer auction services (e. g. British Midland flights), Amazon for BOL in the book market and Freeserve for BT in the provision of consumer ISP services.

However, we must be careful here in the use of the term substitutes. Whilst Amazon and BOL may offer the same books for sale, the additional services they offer differentiate their products. These factors include non-price factors such as delivery or after sales service. Firms attempt to differentiate as otherwise they are treated as ‘commodities’ and prices are driven down. This leads to what is known as monopolistic competition, a model we will examine later.

The debate about the future of Internet access poses some interesting questions. Will mobile devices (e. g. WAP) replace or substitute PCs or will they be complements, as for example, handheld devices such as the Psion which have been used by consultants to record time spent on a particular job with these details later being consolidated on a PC for billing purposes. 3. 2 Price elasticity of demand This is a measure of how responsive demand is to changes in price. The formula is as given: Percentage change in quantity demanded/Percentage change in price For example, if the price increases by 5% and demand falls by 10% we have an elasticity of -2 (-0. 1/+0. 05)=-2).

If price increases by 20% and demand stays the same we have an elasticity of 0, or perfectly inelastic demand (0/+0. 2 =0). Elasticities for most products are negative. The concept of elasticity is critical for decision makers as it guides them in their pricing policies. Self-assessment questions Calculate the price elasticity of demand for the following products. • A price increase of 10% leads to a fall in quantity demanded of 10% • A price increase of 10% leads to no change in quantity demanded

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