Transcript Document

Demand: The Benefit
Side of the Market
Stephen Chiu
University of Hong Kong
1
The Law of Demand
 People do less of what they want to do as the cost of
doing it rises.
 Thus, we eat less of ice cream when it is more
expensive.
 Law of Demand
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The Law of Demand
 The benefit of an activity to me equals the highest price I’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
3
Translating Wants into Demand
 How should we allocate our income among the various
goods and services that are available?
4
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.
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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.
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Example 5.1.
John’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 John 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
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Example 5.2.
John’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
John’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
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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.
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The optimal combination of goods
 The optimal combination of goods is the
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.
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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.
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Example 5.3. Is Susan maximizing her utility
from consuming cashews and pistachios?
 Cashew nuts sell for $8 per pound and pistachios sell
for $4 per pound. Susan 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 5.3. Is Susan 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,
Susan is spending her entire $800 annual budget for nuts.
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Example 5.3. Is Susan 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.
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Example 5.3. Is Susan 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 Susan cannot possibly be
maximizing her total utility.
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Example 5.4. Is Susan maximizing her utility
from consuming cashews and pistachios (III)?
 Susan’s total nut budget and the prices of the two
flavors are again as in Examples 5.3.
 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?
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Example 5.7. Is Susan 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 Susan has it just right.
At her current consumption levels, marginal utility per dollar is
(24 utils/lb)/($8/lb) = (12 utils/lb)/($4/lb) = 3 utils per dollar
for each type of nut.
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The Rational Spending Rule for two goods, X
and Y:
 MUX/PX = MUY/PY.
 Suppose MUX/PX > MUY/PY.
 Then you can increase total utility by spending a dollar
less on Y and a dollar more on X.
 Suppose MUX/PX = 3 > MUY/PY = 2.
 Then by spending a dollar less on Y (lose 2 utils) and a
dollar more on X (gain 3 utils) you can achieve a net
gain of 1 util for the same expenditure.
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The Rational Spending Rule for N goods:
MU1/P1 = MU2/P2 = ... = MUN/PN .
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Law of demand
 Substitution is the most important reason for the law of
demand.
 When the price of something rises, we turn to
substitutes.
20
Example: When the price of energy rises …
We buy smaller cars …
21
Example: When the price of energy rises …
Sell our cars … take public transportation …
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Adding Individual Demand Curves To Get
Market Demand Curves (Horizontal Addition)
 Suppose that there are only two buyers—Smith and
Jones—in the market for cashews, and that their
demand curves are as shown in the following slide.
 To construct the market demand curve for cashews, we
simply announce a sequence of prices and then add the
quantity demanded by each buyer at each price to
obtain the total quantity demanded.
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Adding Individual Demand Curves To Get
Market Demand Curves (Horizontal Addition)
Price
($/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)
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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.
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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.
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Example 5.5. 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
= $30/day
16
14
12
10
44
33
22
D
D
11
units/day
10 11
11 12
12 units/day
11 22 33 44 55 66 77 88 99 10
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Example 5.6. How much do buyers benefit from their
participation in this market for cashews?
Price
($/pound)
12
10
8
6
4
2
S
D
0
2
4
6
8
Quantity
(1000s of
10 12 pounds/day)
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Example 5.6. 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)
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End
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