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Demand: The Benefit
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The Law of Demand

People do less of what they want to do
as the cost of doing it rises
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 2
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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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 3
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The Law of Demand

The Origins of Demand

What determines “tastes” or “preferences”?
 Biology
 Culture
 Peer
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Influences
Chapter 5: Demand: The Benefit Side of the Market
Slide 4
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The Law of Demand

Economic Naturalist

Needs vs. Wants
 Why
does California experience chronic water
shortages?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 5
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Translating Wants into Demand

How should we allocate our incomes
among the various goods and services
that are available?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 6
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Translating Wants into Demand

Measuring Wants: The Concept of Utility

Utility
 The
satisfaction people derive from their
consumption activities

Assumption
 People
allocate their income to maximize their
satisfaction or total utility
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 7
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Sarah’s Total Utility
from Ice Cream Consumption
Cone quantity (cones/hour)
Total utility (utils/hour)
0
0
1
50
2
90
3
120
4
140
5
150
6
140
How much ice cream should Sarah
consume if the ice cream is “free”?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 8
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Sarah’s Total Utility
from Ice Cream Consumption
150
140
Utils/hour
120
90
50
0
1
2
3
4
5
6
Cones/hour
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 9
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Translating Wants Into Demand

What should Sarah do when she gets to
the front of the line?

What do you think?

Is the time spent in the line relevant to how
many cones to order?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 10
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Sarah’s Total Utility and Marginal
Utility from Ice Cream Consumption
Cone quantity
(cones/hour)
Total utility
(utils/hour)
0
0
1
50
2
90
3
120
4
140
5
150
6
140
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Marginal utility
(utils/cone)
Chapter 5: Demand: The Benefit Side of the Market
__
50
40
30
20
10
-10
Slide 11
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Diminishing Marginal Utility
50
Sarah’s
marginal
utility
Utils/cone
40
30
20
10
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
Cones/hour
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 12
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Translating Wants into Demand

The Law of Diminishing Marginal Utility

The tendency for the additional utility
gained from consuming an additional unit
of a good to diminish as consumption
increases beyond some point
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 13
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Translating Wants into Demand

Allocating A Fixed Income Between Two
Goods

Assume
 Two
goods: Chocolate and vanilla ice cream
 Price of chocolate equals $2/pint
 Price of vanilla equals $1/pint
 Sarah’s budget = $400/yr
 Currently Sarah is consuming 200 pints of
vanilla and 100 pints of chocolate
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 14
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Translating Wants into Demand

Question

Is Sarah maximizing her total utility?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 15
12
(utils/ pint)
Marginal Utility Curves for
Two Flavors of Ice Cream (I)
Marginal utility of chocolate ice cream
(utils/ pint)
Marginal utility of vanilla ice cream
MB MC
16
200
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
100
Pints/yr
Slide 16
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Translating Wants into Demand

Marginal utility vanilla/P


$12/1 = 12 utils/$
Marginal utility chocolate/P

16/2 = 8 utils/$
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 17
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Translating Wants into Demand

If Sarah spends $2 less on chocolate,
utils will decline by 16.

If Sarah spends $2 more on vanilla, utils
will increase by 24

So…

Sarah should buy more vanilla
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 18
Marginal Utility Curves for
Two Flavors of Ice Cream (II)
Marginal utility of vanilla ice cream
Sarah increases vanilla
spending by $100, and
MUV/PV = 8/$1 = 8
(utils/ pint)
MB MC
12
8
200
300
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 19
Marginal Utility Curves for
Two Flavors of Ice Cream (II)
Sarah decreases chocolate
spending by $100, and
MUC/PC = 24/$2 = 12 >
MUV/pV = 8
24
(utils/ pint)
Marginal utility of chocolate ice cream
MB MC
16
50
100
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 20
Marginal Utility Curves for
Two Flavors of Ice Cream (III)
MU Vanilla
10

Price Vanilla
1
(utils/ pint)
Marginal utility of vanilla ice cream
MB MC
10
250
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 21
Marginal Utility Curves for
Two Flavors of Ice Cream (III)
MU Chocolate
20

Price Chocolate
2
(utils/ pint)
Marginal utility of chocolate ice cream
MB MC
20
75
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 22
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Translating Wants into Demand

The Rational Spending Rule

Spending should be allocated across
goods so that the marginal utility per dollar
is the same for each good.
MUC MUV

PC
PV
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 23
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Translating Wants into Demand

The Rational Spending Rule

How is the rational spending rule related to
the cost-benefit principle?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 24
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Translating Wants into Demand

Income and Substitution Effects
Revisited

How should Sarah respond to a reduction
in the price of chocolate ice cream?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 25
10
MU Chocolate
20

Price Chocolate
2
(utils/ pint)
Marginal utility of chocolate ice cream
Marginal Utility Curves for
Two Flavors of Ice Cream (III)
MU Vanilla
10

Price Vanilla
1
(utils/ pint)
Marginal utility of vanilla ice cream
MB MC
20
250
Pints/yr
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
75
Pints/yr
Slide 26
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Translating Wants into Demand

Assume
Budget = $400
 PC = $2 & PV = $1
 QC = 75 & QV = 250

MUC 20 MUV 10



PC
2
PV
1
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 27
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Translating Wants into Demand

Assume

Price of chocolate falls to $1
MUC 20 MUV 10



PC
1
PV
1
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 28
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
Applying the
Rational Spending Rule
Economic Naturalist

Why do the wealthy in Manhattan live in
smaller houses than the wealthy in
Seattle?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 29
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
Applying the
Rational Spending Rule
Economic Naturalist

Why did people turn to four-cylinder cars in
the 1970s only to shift back to six- and
eight-cylinder cars in the 1990s?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 30
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
Applying the
Rational Spending Rule
Economic Naturalist

Why are automobile engines smaller in
England than in the United States?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 31
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
Applying the
Rational Spending Rule
The Importance of Income Differences

Why are waiting lines longer in poorer
neighborhoods?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 32
Individual and Market
Demand Curves for Canned Tuna
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1.60
1.60
1.40
1.40
1.20
1.20
Price ($/can)
Price ($/can)
Horizontal Addition
1.00
.80
.60
.40
Smith
.20
0
2
4
6
8
+
1.00
.80
.60
.40
Jones
.20
0
2
Smith’s quantity
(cans/week)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
4
6
Jones’s quantity
(cans/week)
Slide 33
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Individual and Market
Demand Curves for Canned Tuna
1.60
Price ($/can)
1.40
=
1.20
1.00
.80
Market
Demand
curve
.60
.40
.20
0
2
4
6
8
10
12
Total quantity
(cans/week)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 34
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The Individual and Market Demand Curves
When All Buyers Have Identical Demand Curves
6
6
5
5
Price ($/can)
Price ($/can)
•Each of 1,000 consumers have the same demand
•Market Demand = P x number of consumers (1,000)
4
3
2
1
0
D
2
4
6
8
Quantity
(cans/month)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
10
12
4
3
2
1
0
D
2
4
6
8
10
Quantity
(1000s of cans/month)
Chapter 5: Demand: The Benefit Side of the Market
Slide 35
12
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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
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 36
A Market with a
“Digital” Demand Curve
(utils/ pint)
Marginal utility of vanilla ice cream
MB MC
12
11
10
9
8
7
6
5
4
3
2
1
0
Demand
1
2
3
4
5
6
7
8
9
10 11 12
Units/day
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 37
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(utils/ pint)
Marginal utility of vanilla ice cream
Consumer Surplus
12
11
10
9
8
7
6
5
4
3
2
1
0
Consumer surplus
= $15/day
Demand
1
2
3
4
5
6
7
8
9
10 11 12
Units/day
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 38
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Demand and Consumer Surplus

Question

How much do buyers benefit from their
participation in the market for milk?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 39
Supply and Demand
in the Market for Milk
MB MC
S
Price ($/gallon)
3.00
2.50
2.00
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1,000s of
gallons/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 40
Consumer Surplus
in the Market for Milk
MB MC
•h = $1/gallon
•b = 4,000
•Consumer surplus =
(1/2)(4,000)(1) =
$2,000/day
Consumer surplus
S
Price ($/gallon)
3.00
2.50
2.00
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1,000s of
gallons/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 41
End of
Chapter
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MC