Demand: The Benefit Side of the Market

Demand: The Benefit Side of the Market

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Law of DemandLaw of Demand

Law of Demand People do less of what they want to do as

the cost of doing it risesRecall the Cost-Benefit Principle

Pursue an action if and only if its benefits are at least as great as its costs

Recall the Reservation PriceThe highest price we’d be willing to pay

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UtilityUtilityUtility represents the satisfaction people

derive from consumption activitiesUtility Maximization refers to people trying

and allocate their incomes to maximize their satisfaction

Normally, the more we consume, the more total utility we have (assumes goods are good)

At the margin however, incremental utility decreases in quantity – law of diminishing marginal utility

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Marginal UtilityMarginal Utility

The additional utility gained from consuming an additional unit of the goodThe movement from one quantity to the next

The Law of Diminishing Marginal UtilityAs consumption of a good increases beyond some

point, the additional utility gained from an additional unit of the good tends to decline

I.E., when the second good does not double our utility

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Fig. 5.2 Total Utility from

Ice Cream Consumption

Fig. 5.2 Total Utility from

Ice Cream Consumption

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Optimal CombinationOptimal Combination

When buying a variety of goods, how do we maximize total utility?

The optimal combination of goods to purchase is the affordable combination that yields the highest total utility

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Rational Spending RuleRational Spending RuleSuppose we are purchasing 2 goods: C and SSpending should be allocated across goods so that the marginal utility per dollar (“bang-for-the- buck”) is the same for each good

MU

P

MU

PC

C

S

S

the marginal utility per dollar =MU

PThe ratio of marginal utility to price must be the same for each good the consumer buys

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Rational Spending RuleRational Spending Rule

What should you do if: MUc/Pc > MUs/Ps ?E.g. you get 20 units of utility per dollar

spent on C and only 16 units of utility per dollar spent on S.

You should buy more C and less S to increase total utility without spending any more money.

But, what happens when you do this??

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Rational Spending RuleRational Spending Rule

As you buy more of the higher MU/P good its MU decreases (law of DMU).

As you buy less of the lower MU/P good its MU increases (law of DMU in reverse).

Eventually, the MU/P will be equal, and you cannot increase utility further by moving your dollars around.

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Exercise #4 p 138Exercise #4 p 138

Toby’s current marginal utility from consuming peanuts is 100 units of utility per once, and his marginal utility from cashews is 200 units of utility per once. The price of peanuts is 10 cents per once, and the price of cashews is 25 cents per once.

Is Toby maximizing his total utility from the consumption of these 2 goods?

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Exercise #4 p 138Exercise #4 p 138

Peanuts:MU/$ = 100/.10 = 1000

Cashews:MU/$ = 200/.25 = 800

Peanuts yield higher marginal utility per dollar and are therefore a “better deal”. He should consumer more peanuts and less cashews to increase total utility.

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Individual vs. Market Demand

Individual vs. Market Demand

How do we “add-up” the individual demands for all consumers in a market to form the market demand curve?

Option 1: add all prices and quantitiesOption 2: add all prices at each

quantity demandedOption 3: add quantities demanded at

each price

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Individual vs. Market Demand

Individual vs. Market Demand

Option 3 is correct: to find the market quantity demanded at each price, simply add the individual quantities demanded

This should make sense, because consumers face the same set of prices, but have different quantities demanded.

This is called “horizontal summation” because we are adding along the horizontal (quantity) axis

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Fig. 5.4 Individual and Market Demand Curves

for Canned Tuna

Fig. 5.4 Individual and Market Demand Curves

for Canned Tuna

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Consumer SurplusConsumer Surplus

What happens when you purchase something for a price that is less than your maximum willingness to pay?

E.g. you are willing to pay $20,000 for a new car and you buy it for 18,000

You receive a “surplus” of benefit over cost = $2,000

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Consumer Surplus and Demand

Consumer Surplus and Demand

Consumer surplus for a given quantity is therefore the difference between your maximum willingness to pay (reservation price) and what you actually paid (actual price).

CS = the sum of the difference between MB and MC (price) for all units consumed

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Consumer Surplus and Demand

Consumer Surplus and Demand

Graphically then, CS is the area above the price line and below the demand curve, up to Q*

Here, CS = $200

=½(base)(height)

= ½(20)(20)

S

D

P

40

20

20 Q

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Consumer SurplusConsumer Surplus

Q MB (demand) MC (P)

1 100 40

2 80 40

3 60 40

4 40 40

5 20 40

What is the optimal quantity to consume, and how much is consumer surplus?

Q* = 4 units (MC =MC) and CS = $120