MBMC Demand: The Benefit Side of The Market. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit

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Demand: The Benefit Side of The Market

Demand: The Benefit Side of The Market

Chapter 5: Demand: The Benefit Side of the Market Slide 2

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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

The Law of Demand

People do less of what they want to do as the cost of doing it rises


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The Law of Demand

The benefit of an activity equals the highest price we’d be willing to pay to pursue it (i.e., the reservation price).

As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued.


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The Law of Demand

The Origins of DemandWhat determines “tastes” or “preferences”?

BiologyCulturePeer Influences


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The Law of Demand

Economic NaturalistNeeds vs. Wants

Why does California experience chronic water shortages?


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Translating Wants into Demand

How should we allocate our incomes among the various goods and services that are available?


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Measuring Wants: The Concept of UtilityUtility

The satisfaction people derive from their consumption activities

AssumptionPeople allocate their income to maximize their

satisfaction or total utility


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Sarah’s Total Utility from Ice Cream Consumption

Cone quantity (cones/hour) Total utility (utils/hour)

0 0

1 50

2 90

3 120

4 140

5 150

6 140

How much ice cream should Sarahconsume if the ice cream is “free”?


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Sarah’s Total Utility from Ice Cream Consumption

Cones/hour

Uti

ls/h

ou

r

1 3 4 5 60 2

150140

120

90

50


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Translating Wants Into Demand

What should Sarah do when she gets to the front of the line?

What do you think?Is the time spent in the line relevant to how

many cones to order?


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Sarah’s Total Utility and Marginal Utility from Ice Cream Consumption

Cone quantity Total utility Marginal utility(cones/hour) (utils/hour) (utils/cone)

0 0

1 50

2 90

3 120

4 140

5 150

6 140

50

40

30

20

10

-10

__


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Sarah’smarginalutility

Diminishing Marginal Utility

Cones/hour

Uti

ls/c

on

e

1 34.5

01.50.5

43.52.5

2

50

40

30

20

10


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The Law of Diminishing Marginal UtilityThe tendency for the additional utility

gained from consuming an additional unit of a good to diminish as consumption increases beyond some point


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Allocating A Fixed Income Between Two GoodsAssume

Two goods: Chocolate and vanilla ice creamPrice of chocolate equals $2/pintPrice of vanilla equals $1/pintSarah’s budget = $400/yrCurrently Sarah is consuming 200 pints of

vanilla and 100 pints of chocolate


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QuestionIs Sarah maximizing her total utility?


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Marginal Utility Curves for Two Flavors of Ice Cream (I)

Pints/yr

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

Mar

gin

al u

tilit

y o

f ch

oco

late

ice

crea

m

(uti

ls/ p

int)

Pints/yr

12

200

16

100


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Marginal utility vanilla/P$12/1 = 12 utils/$

Marginal utility chocolate/P16/2 = 8 utils/$


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If Sarah spends $2 less on chocolate, utils will decline by 16.

If Sarah spends $2 more on vanilla, utils will increase by 24

So…Sarah should buy more vanilla


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Marginal Utility Curves for Two Flavors of Ice Cream (II)

Pints/yr

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

12

200

8

300

Sarah increases vanillaspending by $100, andMUV/PV = 8/$1 = 8


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Marginal Utility Curves for Two Flavors of Ice Cream (II)

Mar

gin

al u

tilit

y o

f ch

oco

late

ice

crea

m

(uti

ls/ p

int)

Pints/yr

16

100

24

50

Sarah decreases chocolatespending by $100, andMUC/PC = 24/$2 = 12 >MUV/pV = 8


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Marginal Utility Curves for Two Flavors of Ice Cream (III)

Pints/yr

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

10

250

1

10

VanillaPrice

Vanilla

MU


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Mar

gin

al u

tilit

y o

f ch

oco

late

ice

crea

m

(uti

ls/ p

int)

Pints/yr

20

75

2

20

Chocolate Price

Chocolate

MU


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The Rational Spending RuleSpending should be allocated across

goods so that the marginal utility per dollar is the same for each good.

V

V

C

C

P

MU

P

MU


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The Rational Spending RuleHow is the rational spending rule related to

the cost-benefit principle?


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Income and Substitution Effects RevisitedHow should Sarah respond to a reduction

in the price of chocolate ice cream?


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Pints/yr

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

Mar

gin

al u

tilit

y o

f ch

oco

late

ice

crea

m

(uti

ls/ p

int)

Pints/yr

10

250

20

75

1

10

VanillaPrice

Vanilla

MU2

20

Chocolate Price

Chocolate

MU


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Assume Budget = $400PC = $2 & PV = $1

QC = 75 & QV = 250

1

10

P

MU

2

20

P

MU

V

V

C

C


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Assume Price of chocolate falls to $1

1

10

P

MU

1

20

P

MU

V

V

C

C


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Applying theRational Spending Rule

Economic NaturalistWhy do the wealthy in Manhattan live in

smaller houses than the wealthy in Seattle?


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Economic NaturalistWhy did people turn to four-cylinder cars in

the 1970s only to shift back to six- and eight-cylinder cars in the 1990s?


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Economic NaturalistWhy are automobile engines smaller in

England than in the United States?


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The Importance of Income DifferencesWhy are waiting lines longer in poorer

neighborhoods?


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Individual and Market Demand Curves for Canned Tuna

Pri

ce (

$/ca

n)

Smith’s quantity

1.20

6

1.40

1.60

1.00

.80

.60

.40

.20

0

(cans/week)

2 4 8

Pri

ce (

$/ca

n)

Jones’s quantity

60

(cans/week)

2 4

Smith Jones+

Horizontal Addition

1.20

1.40

1.60

1.00

.80

.60

.40

.20


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Individual and Market Demand Curves for Canned Tuna

Pri

ce (

$/ca

n)

Total quantity

60

(cans/week)

2 4 8 1210

=

MarketDemandcurve

1.20

1.40

1.60

1.00

.80

.60

.40

.20


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The Individual and Market Demand Curves When All Buyers Have Identical Demand Curves

Pri

ce (

$/ca

n)

Quantity

6

6

5

4

3

2

1

0

(cans/month)

2 4 8 1210

D

Quantity

6

6

5

4

3

2

1

0

(1000s of cans/month)

2 4 8 1210

D

Pri

ce (

$/ca

n)

•Each of 1,000 consumers have the same demand•Market Demand = P x number of consumers (1,000)


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Demand and Consumer Surplus

Consumer SurplusThe difference between a buyer’s

reservation price for a product and the price actually paid


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Demand

A Market with a “Digital” Demand Curve

Units/day

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

1

1

2

3

4

5

6

7

8

9

10

11

12

2 3 4 5 6 7 8 9 10 11 120


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Consumer Surplus

Units/day

Mar

gin

al u

tilit

y o

f va

nill

a ic

e cr

eam

(uti

ls/ p

int)

1

1

2

3

4

5

6

7

8

9

10

11

12

2 3 4 5 6 7 8 9 10 11 12

Demand

0

Consumer surplus= $15/day


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Demand and Consumer Surplus

QuestionHow much do buyers benefit from their

participation in the market for milk?


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Supply and Demand in the Market for Milk

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

S

D


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Consumer Surplus in the Market for Milk

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

S

D

Consumer surplus •h = $1/gallon•b = 4,000•Consumer surplus = (1/2)(4,000)(1) = $2,000/day

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MBMC Demand: The Benefit Side of The Market. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit