Download Chapter 5

Econ 2610: Principles of
Microeconomics
Yogesh Uppal
Email: [email protected]
LO 5 - 1
Chapter 5
LO 5 - 1
Demand
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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Cost-Benefit Principle at work


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
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Origins of Demand

Determinants of reservation price

Individual tastes and preferences differ




Biological needs
Peer behavior
Perceived quality
■
■
■
Cultural influences
Individual differences
Expected benefits
Tastes may change over time



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Macaroni and cheese
Spinach
Bell-bottoms
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
Utils/hour
Cones /
Hour
Total Utility
0
1
2
0
50
90
4
5
90
50
2
6
120 140 150 140
150
140
120
1
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3
3
4
Cones/hour
5
6
Sarah's Marginal Utility from Ice
Cream
Cones /
Hour
Total Utility
Marginal
Utility

0
1
2
3
4
0
50
90
120 140 150 140
50
40
30
20
5
10
6
-10
Marginal utility: the additional utility from
consuming one more
Change in utility
Marginal utility =
Change in consumption
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Diminishing Marginal Utility
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
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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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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
LO 5 - 1
Marginal utility
increases as
quantity
decreases
Marginal Utility

Marginal Utility
Spending on Two Goods
Marginal utility
decreases as
quantity
increases
Rational Spending Rule
The Rational Spending Rule
Spending should be allocated across goods so that
the marginal utility per dollar
is the same for each good
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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

LO 5 - 1
Marginal utilities per dollar begin to equalize
Sarah's Ice Cream


Chocolate is $2 per pint
Vanilla is $1 per pint
Vanilla
Ice Cream
12
200
Pints/yr
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Buy 200 pints of vanilla
and 100 pints of
chocolate

Marginal utility is 12 for
vanilla, 16 for chocolate
MU (utils/ pint)
$400 budget
MU (utils/ pint)


Chocolate
Ice Cream
16
100
Pints/yr
Sarah's Choices
Vanilla
100
150
200
250
300
MU
16
14
12
10
7
chocolate
150
125
100
75
50
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MU / $
16
14
12
10
7
MU MU / $
8
4
12
6
16
8
20
10
24
12
TU
1600
2100
2400
2500
2100
TU
1200
1500
1600
1500
1200
Sarah's Next Step

Increase vanilla by 100
Reduce chocolate by 50
Vanilla
Ice Cream
12
8
200
Pints/yr
LO 5 - 1

MU (utils/ pint)

MU (utils/ pint)

Marginal utility of
vanilla is 8
Marginal utility of
chocolate is 24
300
24
Chocolate
Ice Cream
16
50
100
Pints/yr
Sarah's Equilibrium


Vanilla
Ice Cream
10
250
Pints/yr
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Marginal utility / price
is the same for all
goods
Marginal utility of vanilla
10, chocolate 20
MU (utils/ pint)

Optimal combination:
highest total utility
250 pints vanilla; 75
pints chocolate
MU (utils/ pint)

Chocolate
Ice Cream
20
75
Pints/yr
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
LO 5 - 1
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.
LO 5 - 1
Eric's Apples
Total
Expenditures
Price
Total Utility
Quantity
Apples
Oranges
$100
$50
$2
1,000
50
$1
400
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
LO 5 - 1

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
LO 5 - 1


Marginal utility (utils/ pint)
Consumer Surplus on a Graph
Vanilla Ice Cream
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
Units/day
10
12



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 $6
 Selling 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
LO 5 - 1
Marginal utility (utils/ pint)
Consumer Surplus on a Graph
Vanilla Ice Cream
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
Units/day
10
12
Consumer Surplus for Milk
Consider the market
demand and supply of
milk

The equilibrium price is $2
per gallon
The equilibrium quantity is
4,000 gallons per day
 Last customer pays his
reservation price and gets
no consumer surplus

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Consumer
Surplus
3.00
Price ($/gallon)

S
2.00
D
1.00
1
2
3
4
5
6
Quantity (000s of gal/day)