Download Chapter 5

Chapter 5
ELEMENTS OF DEMAND AND
CONSUMER CHOICE
Learning objectives
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 Understand how consumers can optimize
 Given that we have limited income, what is the best
combination of goods to consume?
 For a single good, how can we maximize consumer surplus?
 Understand how to sum individual demand curves to
create a market demand curve
Law of Demand
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 Law of Demand
 People do less of what they want to do as the cost of doing it
rises
 Recall the Cost-Benefit Principle
 Pursue an action if and only if its benefits are at least as great
as its costs
 Recall the consumer reservation price
 The highest price you’d be willing to pay
“Utility”
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 Utility represents the satisfaction people derive
from consumption activities
 Utility Maximization refers to people trying
and allocate their incomes to maximize their
satisfaction
 Normally, the more we consume, the more
total utility we have (assumes goods are good)
 At the margin however, incremental utility
decreases in quantity – law of diminishing
marginal utility
Total Utility from Ice Cream Consumption
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How does utility affect our purchase decisions?
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1973 Pinto Squire
Utility = 500
2011 Audi TT
Utility = 50,000
(the Audi is 100 times more
satisfying than the Pinto)
How does utility affect our purchase decisions?
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Do we have enough
information to decide which
car to purchase?
Is utility enough?
How does utility affect our purchase decisions?
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 We also need to know prices.
 2011 Audi TT Price = $40,000
 1973 Pinto Squire Price = $200
 Which car is a “better deal”?
 Audi: 50,000 units of satisfaction for $40,000
 = 1.25 units of utility per dollar spent
 Pinto: 500 units of satisfaction for $200
 = 2.5 units of utility per dollar spent
Bang-for-the-buck
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 Utility per dollar (or marginal utility per dollar) gives
us the value of the purchase per dollar spent.
 Utility per dollar = satisfaction / price
Optimal Combination
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 When buying a variety of goods, how do we
maximize total utility?
 The optimal combination of goods to purchase is the
affordable combination that yields the highest total
utility.
Rational Spending Rule
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o Suppose we purchase 2 goods: Candy (C) and Soda (S)
o Spending should be allocated across goods so that the
marginal utility per dollar (“bang-for-the- buck”) is the same
for each good:
MUC
MU S

PC
PS
MU
o the marginal utility per dollar =
P
o The ratio of marginal utility to price must be
the same for each good the consumer buys
Rational Spending Rule
 What should you do if: MUc/Pc > MUs/Ps ?
 E.g. you get 20 units of utility per dollar spent on
C and only 16 units of utility per dollar spent on S.
 You should buy more C and less S to increase
total utility without spending any more money.
 But, what happens when you do this??
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Rational Spending Rule
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 As you buy more of the higher MU/P good its MU
decreases (law of DMU).
 As you buy less of the lower MU/P good its MU
increases (law of DMU in reverse).
 Eventually, the MU/P will be equal, and you cannot
increase utility further by moving your dollars
around.
Consumer equilibrium
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 Applying the rational spending rule leads to a stable
purchases (sometimes called a “consumer
equilibrium” ).
 Once you’ve found the optimal combination of
goods, there’s no reason to purchase any other
combination, unless…


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Preferences change
Prices change
Income changes
Exercise
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 Toby’s current marginal utility from consuming
peanuts is 100 units of utility per ounce, and his
marginal utility from cashews is 200 units of utility
per ounce.
 The price of peanuts is 10 cents per once, and the
price of cashews is 25 cents per ounce.
 Is Toby maximizing his total utility from the
consumption of these 2 goods?
Exercise
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Peanuts:
MU/$ = 100/.10 = 1000
Cashews:
MU/$ = 200/.25 = 800
Peanuts yield higher marginal utility per dollar and
are therefore a “better deal”. He should consumer
more peanuts and less cashews to increase total
utility.
Maximizing Consumer Surplus
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 What happens when you purchase something for a
price that is less than your maximum willingness to
pay?
 E.g. you are willing to pay $20,000 for a new car and
you buy it for 18,000
 You receive a “surplus” of benefit over cost = $2,000
Consumer Surplus and Demand
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 Consumer surplus for a given quantity is therefore
the difference between your maximum willingness to
pay (reservation price) and what you actually paid
(actual price).
 CS = the sum of the difference between MB and MC
(price) for all units consumed
Consumer Surplus and Demand
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 Graphically then, CS is the area above the price line
and below the demand curve, up to Q*
P
Here, CS = $200
40
S
=½(base)(height)
= ½(20)(20)
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D
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Q
Consumer Surplus
What is the optimal quantity to consume, and how
much is consumer surplus?
Q
MB (demand)
MC (P)
1
100
40
2
80
40
3
60
40
4
40
40
5
20
40
Q* = 4 units (MC =MC) and CS = $120
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Individual vs. Market Demand
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 How do we “add-up” the individual demands for
all consumers in a market to form the market
demand curve?
 Option 1: add all prices and quantities
 Option 2: add all prices at each quantity
demanded
 Option 3: add quantities demanded at each price
Individual vs. Market Demand
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 Option 3 is correct: to find the market quantity
demanded at each price, simply add the individual
quantities demanded
 This should make sense, because consumers face
the same set of prices, but have different quantities
demanded.
 This is called “horizontal summation” because we
are adding along the horizontal (quantity) axis
Individual and Market Demand Curves for Canned Tuna
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Exam 1
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 Exam 1 will be available on Blackboard Learn from Tuesday July
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19 (6:00 am) through Wednesday July 20 (midnight).
You will have 90 minutes to complete the exam once you begin.
Be sure to have uninterrupted time available. As soon as you
begin, the clock starts ticking.
You may use lecture notes, textbook and Connect.
Collaboration of any nature with anyone or discussion of the
exam contents prior to Thursday July 21 is strictly prohibited
and will result in an automatic failing grade for the course and
potential disciplinary action by the University.
Format: 25 short answer (m/c, t/f) and 2 essays (with options)
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Short answer questions worth 80 points, essays worth 10 each