Download Ch05 my ppt

Frank & Bernanke
rd
3 edition, 2007
Ch. 5: Demand - The Benefit
Side of The Market
1
Questions

If free ice cream is available between 2
PM and 4 PM, do every one who is
attracted to the site get it?
What is the MC in monetary terms?
 What is the MC in opportunity cost terms?
 How is ice cream allocated among
consumers?

2
Law of Demand
The costly one views an activity, the less
likely one will do it.
 The lower the cost of a good/service/activity,
the more of it will be “consumed.”

3
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.

4
Needs vs Wants
“Californians don’t have as much water as
they need!”
 “Californians don’t have as much water as
they want at the ongoing price of water!”

5
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
6
Sarah’s Total Utility
from Ice Cream Consumption
Cone quantity (cones/hour)
0
1
2
3
4
5
6
Total utility (utils/hour)
0
50
90
120
140
150
140
How much ice cream should Sarah consume if the ice cream is
“free”?
How many cones should she order once she is at the counter?
Is the time spent in the line relevant to how many cones to order?
7
Sarah’s Total Utility
from Ice Cream Consumption
150
140
Utils/hour
120
90
50
0
1
2
3
4
5
6
Cones/hour
8
Sarah’s Marginal Utility from
Ice Cream Consumption
Cone quantity
(cones/hour)
0
1
2
3
4
5
6
Total utility
(utils/hour)
0
50
90
120
140
150
140
Marginal utility
(utils/cone)
50
40
30
20
10
-10
9
Diminishing Marginal Utility
50
Sarah’s
marginal
utility
40
30
20
10
0.5
1
1.5 2
2.5 3
3.5 4
4.5
10
0
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
11
Allocating A Fixed Income
Between Two Goods
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

12
Marginal utility of vanilla ice cream
(utils/ pint)
12
200
Pints/yr
Marginal utility of chocolate ice cream
(utils/ pint)
Marginal Utility Curves for
Two Flavors of Ice Cream
16
100
Pints/yr
13
Is Sarah Maximizing Her Total
Utility?
Marginal utility vanilla/P: $12/1 = 12 utils/$
Marginal utility chocolate/P: 16/2 = 8 utils/$
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 and less chocolate.
14
Is Sarah Maximizing Her
Total Utility?
But how much more vanilla and how much
less chocolate?
 Until MUv/Pv = MUc/Pc
 If MUv/Pv > MUc/Pc then buy more vanilla
and less chocolate.
 If MUv/Pv < MUc/Pc then buy more
chocolate and less vanilla.

15
Sarah increases vanilla
spending by $100, and
MUV/PV = 8/$1 = 8
(utils/ pint)
Marginal utility of vanilla ice cream
Vanilla
12
8
200
300
Pints/yr
16
Sarah decreases chocolate
spending by $100, and
MUC/PC = 24/$2 = 12 >
MUV/pV = 8
24
(utils/ pint)
Marginal utility of chocolate ice cream
Chocolate
16
50
100
Pints/yr
17
Is Sarah Maximizing Her
Total Utility?
Can she improve her position?
 Use the rational decision-making rule.
 Is MU per $ of vanilla greater or less than
MU per $ of chocolate?
 MU/P of vanilla was $8 and MU/P of
chocolate was $12.
 So Sarah should buy more chocolate and
less vanilla.

18
MU Vanilla
10

Price Vanilla
1
(utils/ pint)
Marginal utility of vanilla ice cream
Equilibrium
10
250
Pints/yr
19
MU Chocolate
20

Price Chocolate
2
(utils/ pint)
Marginal utility of chocolate ice cream
Equilibrium
20
75
Pints/yr
20
Equilibrium
Budget = $400
 PC = $2 & PV = $1
 QC = 75 & QV = 250

MUC 20 MUV 10



PC
2
PV
1
21
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
22
Price of chocolate falls to $1
MUC 20 MUV 10



PC
1
PV
1
23
Applying the
Rational Spending Rule




Why do the wealthy in Manhattan live in smaller
houses than the wealthy in Seattle?
Why did people turn to four-cylinder cars in the
1970s only to shift back to six- and eight-cylinder
cars in the 1990s?
Why are automobile engines smaller in England
than in the United States?
Why are waiting lines longer in poorer
neighborhoods?
24
Individual and Market
Demand Curves for Canned Tuna
1.60
1.60
1.40
1.40
1.20
1.20
Price ($/can)
Price ($/can)
Horizontal Addition
1.00
.80
.60
.40
Smith
.20
0
2
4
6
8
+
1.00
.80
.60
.40
Jones
.20
0
2
4
6
Smith’s quantity
Jones’s quantity
(cans/week)
(cans/week)
25
Individual and Market
Demand Curves for Canned Tuna
1.60
Price ($/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)
26
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)
10
12
4
3
2
1
0
D
2
4
6
8
10
12
Quantity
(1000s of cans/month)
27
Consumer Surplus

The difference between a buyer’s
reservation price for a product and the
price actually paid.
P
28
Supply and Demand
in the Market for Milk
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)
29
Consumer Surplus
in the Market for Milk
•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)
30