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Chapter 5: Demand
Food
A
B
Budget line
Clothes
Question: Given that a person can consume a combination of food
and clothes at any point on the budget line, which point would
satisfy the person the most? A or B or any other point?
1
Demand
• People allocate their limited income among different goods
and services to maximize their satisfaction.
– Utility: the satisfaction people derive from consumption
• Subjective
• Not comparable between people
• Individuals’ goal is to maximize their utility
– Revisit the cost-benefit principle
• People would consume one more unit of food only if the
marginal utility of doing so is at least as large as its cost, which
is the utility lost from the reduction in the consumption of
clothes.
2
Utility – An Example
Sarah's Utility from Ice Cream
0
1
2
3
4
5
6
Total Utility
0
50
90
120
140
150
140
Utils/hour
Cones / Hour
150
140
120
90
50
1
2
3
4
Cones/hour
5
6
3
Utility – An Example (Cont.)
Sarah's Marginal Utility from Ice Cream
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: the additional utility from consuming one more
Change in utility
Marginal utility =
Change in consumption
4
Diminishing Marginal Utility
As consumption increases beyond some point , the
marginal utility gained from consuming additional
unit of a good tends to decrease.
5
Marginal Utility
• Given a fixed income, how would a
person choose between two goods in
order to maximize his/her utility from
consumption?
- Compare the marginal utility
gained from choosing one good
with the marginal utility lost from
giving up another good;
- Law of Diminishing Marginal
Utility applies
1 good,
– As you buy P
more of a single
x
εits=marginal utility decreases
Q less of that
slope
– When you buy
good, its
marginal utility increases
6
Utility Maximization – An Example
• $400 budget
ε=
MU (utils/ pint)
• Chocolate is $2 per pint
• Vanilla is $1 per pint
Vanilla
Ice Cream
12
200
Pints/yr
P
Q
• Buy1200 pints of vanilla and
x 100 pints of chocolate
•slope
Marginal utility is 12 for
vanilla, 16 for chocolate
MU (utils/ pint)
Sarah's Ice Cream
Chocolate
Ice Cream
16
100
Pints/yr
7
Utility Maximization – An Example
• Susan can increase her utility by consuming less Chocolate
and more Vanilla
– Reduce one pint of chocolate saves her $2, with which Susan can
buy two more pints of vanilla ($1 per pint);
– Marginal utility lost from giving up one pint of chocolate = 16 utils;
– Marginal utility gained from two more pints of vanilla = 2x12=24
utils;
– Gain > Loss, Susan should buy more vanilla and less chocolate;
– So, under what conditions would Susan maximizes her total utility?
In other words, what is the optimal combination of chocolate and
vanilla that gratifies Susan the most?
8
Utility Maximization – An Example
Vanilla
Ice Cream
12
8
200
Pints/yr
 Marginal utility of vanilla is 8
 Marginal utility of chocolate is
24
MU (utils/ pint)
MU (utils/ pint)
 Increase vanilla by 100
 Reduce chocolate by 50
300
24
Chocolate
Ice Cream
16
50
100
Pints/yr
9
Utility Maximization – An Example
Vanilla
Ice Cream
10
250
Pints/yr
• Marginal utility / price is the
same for all goods
• Marginal utility of vanilla
10, chocolate 20
MU (utils/ pint)
MU (utils/ pint)
• Optimal combination: highest
total utility
• 250 pints vanilla; 75 pints
chocolate
Chocolate
Ice Cream
20
75
Pints/yr
10
Utility Maximization – An Example
Scenario 1
Price
Quantity
Marginal Utility
MU / $
Vanilla
$1
200
12
12
Chocolate
$2
100
16
8
Price
Quantity
Marginal Utility
MU / $
Vanilla
$1
300
8
8
Chocolate
$2
50
24
12
Price
Quantity
Marginal Utility
MU / $
Vanilla
$1
250
10
10
Chocolate
$2
75
20
10
Scenario 2
Scenario 3
11
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
MU1 / P1 = MU2 / P2
12
Rational Spending Rule
• Substitution effect
– Suppose, one starts with MU1/P1=MU2/ P2;
– When P1 increases, MU1/P1<MU2/ P2;
– According to the rational spending rule, one
should increase spending on good 2 and
reduce spending on good 1 until MU1/P1=MU2/
P2 again;
– So explained is the substitution effect.
13
Rational Spending Rule
Eric's Apples
Total Expenditures
Price
Apples
$100
$2
Oranges
$50
$1
Total Utility
Quantity
1,000
50
400
50
 Is Eric following the Rational Spending Rule?
 What matters is the marginal utility in the rational
spending rule.
14
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
15
• Consumer's surplus is the
difference between the
buyer's reservation price
and the market price
• 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
Marginal utility (utils/ pint)
Consumer Surplus
Vanilla Ice Cream
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
10
12
Units/day
16
• 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
Marginal utility (utils/ pint)
Consumer Surplus
Vanilla Ice Cream
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
10
12
Units/day
17
Consumer Surplus: An Example
– Demand curve
– Vertical axis
– Horizontal intercept of
demand curve
– Remember: area of a right
triangle is ½ width times
height
• The area is
½ ($1)(4,000 gal) =
$2,000
Consumer
Surplus
3.00
Price ($/gallon)
• Price is $2 and quantity is
4,000 gallons per day
• Consumer surplus is the
area of the triangle formed
by
S
2.00
D
1.00
1
2
3
4
5
6
Quantity (000s of gal/day)
18