Transcript Chapter 5

Demand: The Benefit
Side of the Market
Introductory Microeconomics
1
The Law of Demand
 People do less of what they want to do as the cost of
doing it rises.
 The cost of an activity, good, or service involves not just
monetary costs, but non-monetary costs as well.
Waiting in the line is
a kind of
nonmonetary cost
2
Recall The Cost-Benefit Principle
 An individual (or a firm or a society) should take an
action if, and only if, the extra benefits from taking the
action are at least as great as the extra costs.
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If ES(x) = B(x) - C(x) > 0, do x; otherwise don't.
Example of x: consuming an additional unit of sushi.
3
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.
 Our “tastes” or “preferences”, and income determine our benefit.
 How is “tastes” or “preferences” determined?
Biology
Culture
Peer Influences
4
Translating Wants into Demand
 How should we allocate our incomes among the various
goods and services that are available?
5
Recall Rules for allocating resources
 The general rule for allocating a resource efficiently
across different production activities is:
 Allocate each unit of the resource to the production
activity where its marginal benefit is highest.
 For a resource that is perfectly divisible, and for
activities for which the marginal product of the resource
is not always higher in one than in the others, the rule
is:
 Allocate the resource so that its marginal benefit is
the same in every activity.
6
Measuring Wants: The Concept of Utility
 Utility
 The satisfaction people derive from their
consumption activities
 Assumption (rationality)
 People allocate their income to maximize their
satisfaction or total utility.
7
Example 5.1.
Taiji’s Total Utility from Sushi Consumption
Total U /hr
0
0
1
50
2
90
3
120
4
140
5
150
6
140
How many pieces of sushi
should Taiji consume if the
sushi is “free”?
150
140
120
Utils/hour
Pieces /hr
90
50
0
1
2
3
4
5
6
Pieces of sushi /hour
8
Example 5.2.
 Taiji has been waiting outside a sushi shop for an hour.
Now he is in the front of the line. He decides to
consume 20 pieces of sushi at the price of $10 each.
 If Taiji has been waiting outside for two hours, should
he consume more of sushi at the same price?
9
Example 5.3.
Taiji’s Marginal Utility from Sushi Consumption
50
Total U Marginal U
0
0
--
1
50
50
2
90
40
3
120
30
4
140
20
5
150
10
6
140
-10
Taiji’s
marginal
utility
40
Utils/cone
Pieces
30
20
10
The marginal utility from
consuming a good is the additional
utility that results from consuming an
additional unit of the good.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
pieces/hour
10
Diminishing Marginal Utility
 The law of diminishing marginal utility says that as
consumption of a good increases beyond some point,
the additional utility that results from an additional unit
of the good declines.
 Exceptions to the law of diminishing marginal utility:
 The unfamiliar food or melody.
11
The optimal combination of goods
 The optimal combination of goods is that
combination that yields the highest total utility among
all the affordable combinations.
Assumption (rationality)
People allocate their income to maximize their satisfaction or total
utility.
12
Example 5.4.
 How many ostrich burgers should Tom consume each week and
how many mango milkshakes?
 Tom derives all of his nourishment from only two foods: ostrich
burgers and mango milkshakes. Ostrich burgers cost $8 per
pound and mango milkshakes cost $4 per pint.
 If Tom has $20 per week to spend on food, what combination of
the two should he eat?
burgers (lb./wk) Utils/wk from burgers Shakes (pints/wk) Utils/wk from shakes
0
0
0
0
.5
10
1
20
1
16
2
30
1.5
20
3
32
2
22
4
33
2.5
23
5
33
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Method 1.
 First list all the combinations of burgers and shakes that cost
$20/wk, and then see which one delivers the highest total utility.
 Ostrich burgers cost $8 per pound and mango milkshakes cost
$4 per pint.
Combinations that cost $20/wk
Total Utility
2.5 lb. of burger, 0 pint of milkshake
23 + 0 =23
2 lb. of burger, 1 pints of milkshake
22 + 20 =42
1.5 lb. of burger, 2 pints of milkshake
20 + 30 =50
1 lb. of burger, 3 pints of milkshake
16 + 32 =48
0.5 lb. of burger, 4 pints of milkshake
10 + 33 =43
0 lb. of burger, 5 pints of milkshake
0 + 33 =33
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Method 2.
 To achieve the highest possible utility from a given
expenditure, divide your purchases among goods so
that the marginal utility of the last dollar spent on each
good is as large as possible.
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Method 2.
Ostrich
burgers cost
$8 per pound
and mango
milkshakes
cost $4 per
pint.
burgers
(lb./wk)
Utils/wk
from
burgers
0
0
.5
10
1
16
1.5
Tom has $20
per week to
spend on food.
20
2
22
2.5
23
MU/$
2 2.5
4 1.5
5
7
Shakes
(pints/wk)
Utils/wk
from
shakes
0
0
MU/$
1 5
1
20
2
30
3 2.5
6
1
3
32
0.25
9 0.125
4
33
5
33
8
0.5
0.25
10 0
16
Exercise
 Everything the same as Example 5.4.. But Ostrich
burgers cost $8 per pound and mango milkshakes cost
$8 per pint.
 Observe how the quantity demanded changes with
price, for both goods.
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Rational Spending Rule
 When the quantity of each good can be varied
continuously, we have The Rational Spending Rule:
 Spending should be allocated across goods so that
the marginal utility per dollar is the same for each
good.
MU1/P1 = MU2/P2
Recall the rule of allocating resources.
For a resource that is perfectly divisible, and for activities for which the
marginal product of the resource is not always higher in one than in the
others, the rule is:
Allocate the resource so that its marginal benefit is the same in
every activity.
18
Example 5.5. Is Sue maximizing her utility
from consuming cashews and pistachios?
 Cashew nuts sell for $8 per pound and pistachios sell
for $4 per pound. Sue has a budget of $800 per year
to spend on nuts, and her marginal utility from
consuming each type of nut varies with the amount
consumed as shown on the next slide.
 If she is currently buying 80 pounds of cashews and 40
pounds of pistachios each year, is she maximizing her
utility?
Cashew
pistachio
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Example 5.5. Is Sue maximizing her utility
from consuming cashews and pistachios?
Marginal utility of
cashews (utils/lb)
Marginal utility of
pistachios (utils/lb)
16
20
80
lb/yr
40
lb/yr
Step 1: Check if all income is spent.
With 80 pounds per year of cashews and 40 pounds of pistachios,
Sue is spending her entire $800 annual budget for nuts.
20
Example 5.5. Is Sue maximizing her utility
from consuming cashews and pistachios?
Marginal utility of
cashews (utils/lb)
Marginal utility of
pistachios (utils/lb)
16
20
80
lb/yr
40
lb/yr
Step 2: Check marginal utility per dollar spent on the two goods.
Her current spending on cashews is yielding
(20 utils/pound)/($8/pound) = 2.5 utils per dollar.
Her current spending on pistachios is yielding
(16 utils/pound)/($4/pound) = 4 utils per dollar.
21
Example 5.5. Is Sue maximizing her utility
from consuming cashews and pistachios?
 So her current spending yields higher marginal utility
per dollar for pistachios than for cashews.
 And this means that Sue cannot possibly be maximizing
her total utility.
22
Example 5.6. Is Sue maximizing her utility
from consuming cashews and pistachios (II)?
 Sue’s total nut budget and the prices of the two types
are the same as in Example 5.5. If her marginal utility
from consuming each type varies with the amount
consumed as shown in the next slide and if she is
currently buying 70 pounds of cashews and 60 pounds
of pistachios each year, is she maximizing her utility?
23
Example 5.6. Is Sue maximizing her utility
from consuming cashews and pistachios (II)?
Marginal utility of
cashews (utils/lb)
Marginal utility of
pistachios (utils/lb)
16
28
20
8
70 80
lb/yr
40 60 lb/yr
The direction of Sue’s rearrangement of her spending makes sense in
light of Example 5.5, in which we saw that she was spending too much
on cashews and too little on pistachios.
Her spending on cashews now yields
(28 utils/pound)/($8/pound) = 3.5 utils per dollar.
Her spending on pistachios now yields
(8 utils/pound)/($4/pound) = 2 utils per dollar.
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Example 5.6. Is Sue maximizing her utility
from consuming cashews and pistachios (II)?
 So at her new rates of consumption of the two types of
nuts, her spending yields higher marginal utility per
dollar for cashews than for pistachios—precisely the
opposite of the ordering we saw in Example 5.5.
 Sue has thus made too big an adjustment in her effort
to remedy her original consumption imbalance.
25
Example 5.7. Is Sue maximizing her utility
from consuming cashews and pistachios (III)?
 Sue’s total nut budget and the prices of the two flavors
are again as in Examples 5.5 and 5.6.
 If her marginal utility from consuming each type varies
with the amounts consumed as shown in the next slide
and if she is currently buying 50 pounds of pistachios
each year and 75 pounds of cashews each year, is she
maximizing her utility?
26
Example 5.7. Is Sue maximizing her utility
from consuming cashews and pistachios (III)?
Marginal utility of
cashews (utils/lb)
Marginal utility of
pistachios (utils/lb)
12
24
75
lb/yr
50
lb/yr
This time Sue has it just right.
At her current consumption levels, marginal utility per dollar is
(24 utils/lb)/($8/lb) = (12 utils/lb)/($4/lb) = 3 utils per dollar
for each type of nut.
27
The Rational Spending Rule for two goods, X
and Y:
 MUX/PX = MUY/PY.
 Suppose MUX/PX > MUY/PY.
 Then you can increase total utility by spending a dollar
less on Y and a dollar more on X.
 Suppose MUX/PX = 3 > MUY/PY = 2.
 Then by spending a dollar less on Y (lose 2 utils) and a
dollar more on X (gain 3 utils) you can achieve a net
gain of 1 util for the same expenditure.
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The Rational Spending Rule for N goods:
MU1/P1 = MU2/P2 = ... = MUN/PN .
29
Law of demand
 Substitution is the most important reason for the law of
demand.
 When the price of something rises, we turn to
substitutes.
30
Example: When the price of energy rises …
We buy hybrid cars …
31
Example: When the price of energy rises …
… take public transportation …
32
Example: When the price of energy rises …
… move closer to work …
33
Example: When the price of energy rises …
… buy more efficient appliances …
34
Example 5.8. Why do the Japanese live in
smaller houses than the Americans?
Why do people in the city live in smaller houses/apartments than
those in the country side?
35
Example 5.8. Why do the Japanese live in
smaller houses than the Americans?
 Cultural differences?
 Yes, but why these cultural differences?
 The differences are a simple consequence of the law of
demand. Market price of all land in Japan (about the
area of California) exceeds the market price of all land
in North and South America and Western Europe
combined.
 Rational Japanese consumers respond by buying
smaller houses.
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Example 5.9. Why this difference?
In the U.S., gravel for road building is made by enormous
machines that crush boulders into smaller stones. In Nepal, gravel
is made by workers who hammer rocks into smaller stones.
 It has nothing to do with the fact that Nepal is “too poor” to afford the
machines used in the U.S.
 The price of labor in Nepal is low relative to the price of capital, whereas
the price of labor in the US is high relative to the price of capital.
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Example 5.10.
 Why do highly industrialized countries typically have less
environmental pollution than less highly industrialized countries?
Industrialized countries
(e.g., United States)
Less industrialized countries
(e.g., Mexico)
38
Example 5.10.
 It might seem more natural to expect the opposite relationship,
since industrial processes themselves are often the source of
environmental pollution.
 But more the more highly industrialized a country is, the higher its
income typically is. And the more income people have, the more
they are willing to spend on equipment and processes that reduce
environmental pollution.
Pollution
Environmental Kuznet curve
Dinda, Soumyananda (2004): “Environmental
Kuznets Curve Hypothesis: A Survey,” Ecological
Economics, 49(4): 431-455.
Industrialization
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Example 5.11.
Why has the price of premium wine risen more
rapidly than the average price of wine?
$6.99
$7.99
1999 Domaine Romanée
Conti: $5,200
40
Example 5.11.
Why has the price of premium wine risen more
rapidly than the average price of wine?
 Wealthy people tend to buy fine wines; people of
average incomes tend to buy wines of average quality.
 Incomes of the top 1 percent of earners have tripled in
real terms since 1979, a period during which median
earnings grew only 15 percent.
 So demand for wines of average quality has remained
stable while demand for premium quality wines has
increased.
41
Adding Individual Demand Curves To Get
Market Demand Curves (Horizontal Addition)
 Suppose that there only two buyers—Smith and Jones—
in the market for cashews, and that their demand
curves are as shown in the following slide.
 To construct the market demand curve for cashews, we
simply announce a sequence of prices and then add the
quantity demanded by each buyer at each price to
obtain the total quantity demanded.
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Adding Individual Demand Curves To Get
Market Demand Curves (Horizontal Addition)
Price
($/lb)
16
14
12
10
8
6
4
2
Price
($/lb)
16
14
12
+
=
10
8
6
4
2
0 4 8 12 16
0 4 8 12 16
Smith's
Jones's
Quantity
Quantity
(lbs/wk)
(lbs/wk)
Price
($/lb)
16
14
12
10
8
Market
6
demand
4
curve
2
0 4 8 12 16 20 24
Total
Quantity
(lbs/wk)
43
Demand and consumer surplus
 Consumer surplus: the difference between a buyer’s
reservation price for a product and the price actually
paid.
 The term sometimes refers to the surplus received by a
single buyer in a transaction, sometimes to denote the
total surplus received by all buyers in a market or
collection of markets.
44
Example 5.12. Calculating Consumer Surplus
 The demand curve in the following slide depicts a
hypothetical market for a good with 11 potential buyers,
each of whom can buy a maximum of one unit of the
good each day. The first potential buyer’s reservation
price for the product is $22; the second buyer’s
reservation price is $20; the third buyer’s reservation
price is $18; and so on.
45
Example 5.12. Calculating Consumer Surplus
Suppose this good were available at a price of $12 per unit.
How much total consumer surplus would buyers in this
market reap?
Price
($/unit)
24
22
20
Consumer Surplus
18
= $30/day
16
14
12
10
44
33
22
D
D
11
units/day
10 11
11 12
12 units/day
11 22 33 44 55 66 77 88 99 10
46
Example 5.13. How much do buyers benefit from their
participation in this market for cashews?
Price
($/pound)
12
10
8
6
4
2
S
D
0
2
4
6
8
Quantity
(1000s of
10 12 pounds/day)
47
Example 5.13. How much do buyers benefit from their
participation in this market for cashews?
 The last unit exchanged each day generates no consumer surplus at all.
 For all cashews sold up to 4,000 pounds per day, buyers receive
consumer surplus.
 Consumer surplus is the cumulative difference between the most they
would be willing to pay for cashews (as measured on the demand
curve) and the price they actually pay.
Price
($/pound)
12
10
8
6
4
2
0
2
Note that this area is a right triangle whose vertical
Consumer
arm is h=$4/pound and whose horizontal arm is
surplus
b=4,000 pounds/day.
S
Since the area of any triangle is
equal to (1/2)bh, consumer
surplus in this market is
equal to (1/2)x(4,000
D
Quantity
pounds/day)x($4/pound) =
(1000s of
$8,000/day.
4 6 8 10 12 pounds/day)
48
Consumer surplus
 A useful way of thinking about consumer surplus is to
ask what is the highest price consumers would pay, in
the aggregate, for the right to continue participating in
this cashew market. The answer is $8,000 per day,
since that is the amount by which their combined
benefits exceed their combined costs.
 Suppose the government bans the operation of the
cashew market. How much will the consumers, in
aggregate, be willing to “bribe” or “lobby” the
government to “re-open” the market?
 $8,000 per day in the previous example.
49
Example 5.14.
Consider the following two long-distance plans:
 AT&T: $20 per month plus 10 cents per minute
 MCI: $40 per month plus 5 cents per minute.
Which of the following statements is NOT true?

✓ a. The AT&T plan is more likely to appeal to people who make
relatively few long-distance calls.
✓ b. The MCI plan is more likely to appeal to people who make
relatively many long-distance calls.
✓ c. A person who is involuntarily transferred from the MCI plan to the
AT&T plan is likely to respond by making fewer long-distance
calls.
d. A rational person will choose the MCI plan only if it results in a
smaller total phone bill than the AT&T plan.
e. Three of the above statements are true.
50
Example 5.14.
 Which of the following statements is NOT true?
d. A rational person will choose the MCI plan only if it
results in a smaller total phone bill than the AT&T
plan.
e. Three of the above statements are true.
If one of the statements is false, it must be d or e.
If d is true, then e must be false (since d being true would
mean that four of the above statements were true).
Conversely, if d is false, e must be true (because a, b and c
are true).
So we must determine whether d is true.
51
Example 5.14.
Many believe that choice d is true.
d. A rational person will choose the MCI plan only if it
results in a smaller total phone bill than the AT&T plan.
A common argument:
“If a rational consumer wanted to place a given
volume of calls each month, she would necessarily
choose the billing plan that resulted in the smallest
monthly bill.”
Is this argument correct?
52
Example 5.14.
Optimal number of calls
given enrollment in the
AT&T plan
Optimal number of
calls given
enrollment in the
MCI plan
10 cents
5 cents
50
53
Example 5.14.
 When the demand is perfectly inelastic, a rational person only need
to compare the costs of the two plans.
 Suppose a person has 1000 dollars to spend a month. If he enrolls
is the MCI plan, he will have to pay 40+0.05*50 = 42.5 on phone
services. If he enrolls in the AT&T plan, he will have to pay
20+0.10*50 = 25.
Number of calls
Other goods
MCI
50 ($42.5)
$957.5=1000-42.5
AT&T
50 ($25)
$975=1000-25
Which do you prefer if you are the person with inelastic demand for calls?
AT&T because we can consume the same number of calls as in MCI but
with more other goods.
54
Example 5.14.
Optimal number of calls
given enrollment in the
AT&T plan
Optimal number of
calls given
enrollment in the
MCI plan
10 cents
5 cents
500
55
Example 5.14.
 When the demand is perfectly inelastic, a rational person only need
to compare the costs of the two plans.
 Suppose a person has 1000 dollars to spend a month. If he enrolls
is the MCI plan, he will have to pay 40+0.05*50 = 65 on phone
services. If he enrolls in the AT&T plan, he will have to pay
20+0.10*500 = 70.
Number of calls
Other goods
MCI
500 ($65)
$935=1000-65
AT&T
500 ($70)
$930=1000-70
Which do you prefer if you are the person with inelastic demand for calls?
MCI because we can consume the same number of calls as in AT&T but
with more other goods.
56
Example 5.14.
Many believe that choice d is true.
d. A rational person will choose the MCI plan only if it
results in a smaller total phone bill than the AT&T plan.
A common argument:
“If a rational consumer wanted to place a given
volume of calls each month, she would necessarily
choose the billing plan that resulted in the smallest
monthly bill.”
This argument is correct but yet its correctness does
not imply that choice d is true.
57
Example 5.14.
 A rational consumer does not necessarily wish to make a given
volume of calls each month, irrespective of the rate at which those
calls are billed.
 On the contrary, such a customer would represent the extreme
case, someone whose demand for telephone services was
completely inelastic with respect to price.
 More generally, consumers will elect to make more calls when they
are on a plan with lower marginal charges.
 The goal of such consumers is not to minimize their monthly phone
bills, but rather to choose the mix of phone services and other
goods that maximizes their utility.
58
Example 5.14.
 Might a rational consumer whose demand for telephone services is
less than perfectly inelastic choose the MCI plan even though she
would have a higher phone bill than under the AT&T plan?
 Consider, for example, a consumer whose demand for phone
service is extremely elastic with respect to price.
 A reduction in the price of an elastically demanded good results in
an increase in total expenditure on that good.
59
Example 5.14.
Optimal number of calls
given enrollment in the
AT&T plan
Optimal number of
calls given
enrollment in the
MCI plan
10 cents
5 cents
50
500
A rational person may compare his total utility from the calling
services and the other goods, NOT the cost.
60
Example 5.14.
 A rational person may compare his total utility from the calling
services and the other goods, NOT the cost.
 Suppose a person has 1000 dollars to spend a month. If he enrolls
is the MCI plan, he will have to pay 40+0.05*500 = 65 on phone
services. If he enrolls in the AT&T plan, he will have to pay
20+0.10*50 = 25.
Number of calls
Other goods
MCI
500 ($65)
$935=1000-65
AT&T
50 ($25)
$975=1000-25
Which do you prefer?
There are persons who may prefer the MCI package but the
phone bill is higher when MCI is chosen.
61
 Because the MCI plan has a lower marginal charge than
the AT&T plan, someone with highly elastic demand for
phone services might choose MCI knowing full well that
the higher volume of calls she would make under it
would result in a higher bill than she would have had
under the AT&T plan.
 Thus d may not be correct when demand for calls is
elastic.
62
End
63