Econ 2610: Principles of Microeconomics
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Transcript of Econ 2610: Principles of Microeconomics
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LO 5 - 1
Chapter 5Demand
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Free Ice Cream – Or Is It?
Costs of a good extend beyond the monetary costs
"Free" ice cream attract so many consumers that the time spent waiting in line acts as the price of the good
Demand curves relate the quantity demanded to ALL costs, not just monetary costs
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Law of Demand
Law of Demand
People do less of what they want to do
as the cost of doing it rises
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Do something if the marginal benefits are at least as great as the marginal costs
If market price exceeds the reservation price, buy no more
Cost-Benefit Principle at work
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Origins of Demand
Determinants of reservation price Individual tastes and preferences differ
Biological needs ■ Cultural influences Peer behavior■ Individual differences Perceived quality ■ Expected benefits
Tastes may change over time Macaroni and cheese Spinach Bell-bottoms
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Wants and Utility
Utility: the satisfaction people derive from consumption Well-being, happiness Measured indirectly
Subjective Observable
Cannot be compared between people Individual goal is to maximize utility
Allocate resources accordingly
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Sarah's Utility from Ice Cream
Cones / Hour
0 1 2 3 4 5 6
Total Utility 0 50 90 120 140 150 140
Cones/hour
Util
s/ho
ur
1 3 4 5 62
150140
120
90
50
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Sarah's Marginal Utility from Ice Cream
Marginal utility: the additional utility from consuming one more
Cones / Hour
0 1 2 3 4 5 6
Total Utility 0 50 90 120 140 150 140
Marginal Utility
50 40 30 20 10 -10
Marginal utility = Change in utility
Change in consumption
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Law of Diminishing Marginal Utility
Tendency for additional utility gained
from consuming an additional unit of a good
to decrease as consumption increases
beyond some point
Diminishing Marginal Utility
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Diminishing Marginal Utility
Marginal utility can increase at low levels of consumption
Eventually marginal utility declines Apply Cost-Benefit Principle
Consume an additional unit as long as the marginal utility (benefit) is greater than the marginal cost
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Spending on Two Goods
Given a fixed budget, law of Diminishing Marginal Returns applies As you buy more of a
single good, its marginal utility decreases
When you buy less of that good, its marginal utility increases
Ma
rgin
al U
tility
Ma
rgin
al U
tilit
y
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The Rational Spending Rule
Spending should be allocated across goods so that
the marginal utility per dollar
is the same for each good
Rational Spending Rule
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Rational Spending Rule
Rational Spending Rule can be written algebraically Notation
MUC is the marginal utility from chocolate
MUV is the marginal utility from vanilla
PC is the price of chocolate
PV is the price of vanilla Rational Spending Rule
MUC / PC = MUV / PV
The marginal utility per dollar spent on chocolate equals the marginal utility per dollar spent on vanilla
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Budget Allocation
Given the budget, the utility is maximized when the marginal utility per dollar spent is the same for all goods Current spending has marginal utility of a dollar
spent on one good higher than the marginal utility of a dollar spent on the other good
Take a dollar away from the good with low marginal utility and spend it on the good with high marginal utility Marginal utilities per dollar begin to equalize
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Sarah's Ice Cream
$400 budget Chocolate is $2 per pint Vanilla is $1 per pint
Buy 200 pints of vanilla and 100 pints of chocolate Marginal utility is 12 for
vanilla, 16 for chocolate
Pints/yr
Vanilla Ice Cream
12
200
MU
(u
tils/
pin
t)
Chocolate Ice Cream
Pints/yr
16
100M
U
(util
s/ p
int)
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Sarah's ChoicesVanilla MU MU / $ TU
100 16 16 1600
150 14 14 2100
200 12 12 2400
250 10 10 2500300 7 7 2100
chocolate MU MU / $ TU 150 8 4 1200
125 12 6 1500
100 16 8 1600
75 20 10 1500
50 24 12 1200
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Sarah's Next Step
Increase vanilla by 100 Reduce chocolate by 50
Marginal utility of vanilla is 8
Marginal utility of chocolate is 24
Chocolate Ice Cream
Pints/yr
16
100M
U
(util
s/ p
int)
50
24
Pints/yr
Vanilla Ice Cream
200
MU
(u
tils/
pin
t)
300
812
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Sarah's Equilibrium Optimal combination:
highest total utility 250 pints vanilla; 75
pints chocolate
Marginal utility / price is the same for all goods Marginal utility of vanilla
10, chocolate 20
MU
(u
tils/
pin
t)
Pints/yr
Vanilla Ice Cream
250
10
MU
(u
tils/
pin
t)
Chocolate Ice Cream
Pints/yr
20
75
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Substitution Effect When the price of a good goes up,
substitutes for that good are relatively more attractive If the price of vanilla ice cream goes up, some
buyers will buy less vanilla and more chocolate
Income Effect Changes in price affect the buyers'
purchasing power
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Suppose price of vanilla increases from $1 to $2
At the original equilibrium
MUC / PC = MUV / PV
With the increase in PV, MUV / PV < MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point,
Buy more chocolate. Buy less vanilla. Stop when the marginal utility per dollar is the same
At new price for vanilla, she buys 100 vanilla and only 100 chocolate
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Suppose Chocolate Ice Cream Price Goes Down from $2 to $1
With the decrease in Pc,
MUV / PV < MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point,
Buy more chocolate, Buy less vanilla, Stop when marginal utility per dollar is the same
At new price for chocolate, she buys somewhere between 250 and 275 vanilla and somewhere between 125 and 150 chocolate.
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LO 5 - 1
Eric's Apples
Apples Oranges
Total Expenditures
$100 $50
Price $2 $1
Total Utility 1,000 400
Quantity 50 50
Is Eric following the Rational Spending Rule?
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Individual and Market Demand Curves The market demand is the horizontal sum of
individual demand curves At each possible price, add up the number of
units demanded by individuals to get the market demand
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Consumer Surplus
Consumer's surplus is the difference between the buyer's reservation price and the market price
With multiple buyers Find the consumer surplus for each buyer Add up the individual surpluses
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Consumer Surplus on a Graph
When a product is sold in whole units, the demand curve is a stair-step function Many goods are indivisible:
movie tickets and TVs If the market supplied only
one unit, the maximum price would be $11 For the second unit, the price
is $10, and so on The last buyer gets no
consumer surplus
D
Units/day
Mar
gina
l util
ity
(util
s/ p
int)
12
34
5
6789
1011
12
2 4 6 8 10 12
Vanilla Ice Cream
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Consumer Surplus on a Graph Market price is $6 for all sales Total consumer surplus
The first sale generates $5 of consumer surplus Reservation price of $11
minus the price of $6Selling the second unit has
$4 of consumer surplus, and so on
Total consumer surplus is the area under the demand curve and above market price
D
Units/day
Mar
gina
l util
ity
(util
s/ p
int)
12
345
67
89
1011
12
2 4 6 8 10 12
Vanilla Ice Cream
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LO 5 - 1
Consumer Surplus for Milk
Consider the market demand and supply of milk
The equilibrium price is $2 per gallon
The equilibrium quantity is 4,000 gallons per day Last customer pays his
reservation price and gets no consumer surplus
Quantity (000s of gal/day)
Pric
e ($
/gal
lon)
1
1.00
2.00
3.00
2 3 4 5 6
S
D
Consumer Surplus