Download L9-consumer econ

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Overview of Market Allocation
• The economic problem
• Overview of markets, supply, demand and
market equilibrium
• Elasticity
• The demand side: benefits
• The Supply side: costs
• Market equilibrium
• Quest for profits and the invisible hand
• Market failures
• Alternatives and policies
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Announcements

Exam next Tuesday

Will post review questions tonight

Tas will be announcing review sessions
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Demand: The Benefit
Side of The Market
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MC
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Goals for this lecture

Understand needs and wants

Neoclassical and alternative approaches

Introduce the concept of utility

Understand the Equimarginal Principle of
Optimization (rational spending rule for
consumers)

Relationship between individual demand
curves and market demand for rival goods

Understand consumer surplus
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 4
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The Law of Demand

People do less of what they want to do as the
cost of doing it rises

‘Cost’ includes all individual costs
(opportunity costs), but generally ignores
costs to society

Is this always true?


E.g. speculation, housing bubble
How do we know what people want to do?


Preferences revealed in the market
Africans ‘want’ to eat less than Americans
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 5
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The Law of Demand

The benefit of an activity to an individual equals
the highest price (including opportunity costs)
she’d be willing to pay to pursue it (i.e., the
reservation price).



‘price’ needn’t be $$
Who gets a greater benefit from food, a malnourished
African or an overfed American?
As the cost to individuals of an activity rises and
exceeds the reservation price (for the marginal
unit), less of the activity will be pursued.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 6
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Examining the assumptions

NYT Headlines

High Prices Help Sell All-in-One
Products

In Tuition Game, Popularity Rises With
Price
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 7
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The Origins of Demand

Needs vs. wants


What determines “tastes” or “preferences”?




Do markets ensure needs are satisfied prior to
wants?
No accounting for tastes. Has nothing to with
moral values
Are preferences exogenous or endogenous?
Advertising- producers create demand
Can needs and tastes be treated the
same?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 8
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The Law of Demand
• The variety of human
needs
– Having, being, doing,
interacting
– How many of these derive
from community?
– Satisfiers and
psuedosatisfiers
• Advertising and wants
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 9
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Advertising and quality of life

What’s a reasonable definition of
quality of life?
“The ability to satisfy your wants and
needs”

What does advertising do to your
wants?

What’s its impact on your ability to
satisfy them?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 10
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Translating Wants into Demand

How should we allocate our incomes
among the various goods and services
that are available?

Demand = preferences (wants)
weighted by income
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 11
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Measuring wants: utility

Utility

Not directly measurable.
 Is


this true for essential, non-substitutable resource?
Revealed preferences
The satisfaction people derive from their
consumption (having) activities
 What
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
about doing activities? Being activities?
Chapter 5: Demand: The Benefit Side of the Market
Slide 12
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Measuring wants: utility

Assumption


People allocate their resources to maximize their
satisfaction or total utility
Do you think this is true?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 13
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Sarah’s Total Utility
from gas Consumption
Gas quantity (gallons/day)
Total utility (utils/day)
0
0
1
50
2
90
3
120
4
140
5
150
6
140
How much gas should Sarah
consume if the gas is “free”?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 14
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Sarah’s Total Utility
from gas Consumption
150
140
Utils/day
120
90
50
0
1
2
3
4
5
6
gallons/day
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 15
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Translating Wants Into Demand

What do you think?
Are the negative impacts of gasoline on
society (e.g. oil spills, climate
destabilization, air pollution, resource wars)
relevant to how much she should order?
 Are they relevant to how much she does
order?
 Is the time spent waiting in gas lines
relevant?

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 16
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Sarah’s Total Utility and Marginal
Utility from gas Consumption
gas quantity
(gallons/day)
Total utility
(utils/day)
0
0
1
50
2
90
3
120
4
140
5
150
6
140
Marginal utility
(utils/gallon)
__
50
40
30
20
10
-10
Do you think Sarah’s utility is the same as society’s utility?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 17
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Diminishing Marginal Utility
50
Sarah’s
marginal
utility
Utils/gallon
40
30
20
10
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
gallons/day
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 18
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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
 What happens if you assume this is not
true?

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 19
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Translating Wants into Demand

Allocating A Fixed Income Between
Two Goods

Assume
 Two
goods: public or private transportation
 Price of public trans. equals $2/trip
 Price of gas equals $1/liter
 Sarah’s budget = $400/yr
 Currently Sarah is consuming 200 liters of gas
and 100 trips on public transportation
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 20
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Translating Wants into Demand

Question

Is Sarah maximizing her total utility?
Copyright c 2004 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 types of transportation (I)
Marginal utility of public
transportation (utils/trip)
(utils/ liter)
Marginal utility of gas
MB MC
12
16
200
liters/yr
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
100
trips/yr
Slide 22
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Translating Wants into Demand

Marginal utility gas/liter


$12/1 = 12 utils/$
Marginal utility pub trans/trip

16/2 = 8 utils/$
Copyright c 2004 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

If Sarah spends $2 less on pub trans, utils will
decline by 16.

If Sarah spends $2 more on gas, utils will
increase by 24

So…


Sarah gets more utility if she buys more gas
How much gas should Sarah buy?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 24
Consuming more gas leads to lower
marginal utility
MU Gas 10

Price Gas
1
(utils/ liter)
Marginal utility of gas
MB MC
10
250
liters/yr
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 25
Consuming less public transportation
leads to higher marginal utility
Marginal utility of public trans. (utils/
trip)
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MU Public Transport 20 10
=
=
Price Public Transport
2
1
20
75
trips/yr
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 26
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The equimarginal principle of
optimization

AKA the rational spending rule

Spending should be allocated across
goods so that the marginal utility per
dollar is the same for each good.
MUPT MUG

PPT
PG
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 27
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The equimarginal principle of
optimization

This applies to all goods

Is it an optimal outcome for society?

How could we improve the outcome?
What will make people consume less of a
good?
 What would happen if we subsidized public
transportation?

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 28
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Translating Wants into Demand

Income and Substitution Effects
Revisited

How should Sarah respond to a reduction
in the price of public transportation?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 29
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Translating Wants into Demand

Assume
Budget = $400
 PPT = $2 & PG = $1
 QPT = 75 & QG = 250

MUPT 20 MUG 10



PPT
2
PG
1
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 30
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Translating Wants into Demand

Assume

Price of public trans.falls to $1
MUPT 20 MUG 10



PPT
1
PG
1

So what should Sarah do?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 31
Individual and Market
Demand Curves for Canned Tuna
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16
16
14
14
12
12
Price ($/can)
Price ($/can)
Horizontal Addition
10
8
6
4
Smith
2
0
2
4
6
8
Smith’s quantity
(cans/week)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
+
10
8
6
Jones
4
2
0
2
4
6
8
Jones’s quantity
(cans/week)
Chapter 5: Demand: The Benefit Side of the Market
Slide 32
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Individual and Market
Demand Curves for Canned Tuna
16
Price ($/can)
14
=
12
10
8
Market
Demand
curve
6
4
2
0
2
4
6
8
10
12
Total quantity
(cans/week)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 33
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Trade-offs: Life
sustaining
benefits
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Value:
Increasing
rapidly with
decreasing
quantity.
Trade-offs:
Resilience,
increasingly
important
benefits
food security, household security
Value: shift from
marginal to total
value (e.g.
diamond-water
paradox)
physiological threshold: e.g. starvation
Individual Demand for food
Value: low and stable
Trade-offs: relatively
unimportant benefits
MB MC
Individual and Market
Demand Curves for Food
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 35
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price
Poor starve,
middle class
goes hungry
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
food security, household security
Market Demand for food
Trade-offs: poor go
hungry
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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
Total quantity
(cans/month)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
10
12
4
3
2
1
0
D
2
4
6
8
10
Total quantity
(1000s of cans/month)
Chapter 5: Demand: The Benefit Side of the Market
Slide 37
12
MB MC
Demand and Consumer Surplus

Consumer Surplus

The difference between a buyer’s
reservation price for a product and the
price actually paid
Copyright c 2004 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 2004 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
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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 2004 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
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•h = $1/gallon
•b = 4,000
•Consumer surplus =
(1/2)(4,000)(1) = $2,000/day
Consumer surplus
S
Price ($/gallon)
3.00
Do we know what the
demand curve looks like?
2.50
2.00
Is this level of precision
appropriate?
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 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 5: Demand: The Benefit Side of the Market
Slide 41