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Econ 2610: Principles of Microeconomics

Yogesh Uppal

Email: yuppal@ysu.edu

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Chapter 5Demand

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Free Ice Cream – Or Is It?

Costs of a good extend beyond the monetary costs

"Free" ice cream attract so many consumers that the time spent waiting in line acts as the price of the good

Demand curves relate the quantity demanded to ALL costs, not just monetary costs

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Law of Demand

Law of Demand

People do less of what they want to do

as the cost of doing it rises

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Do something if the marginal benefits are at least as great as the marginal costs

If market price exceeds the reservation price, buy no more

Cost-Benefit Principle at work

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Origins of Demand

Determinants of reservation price Individual tastes and preferences differ

Biological needs ■ Cultural influences Peer behavior■ Individual differences Perceived quality ■ Expected benefits

Tastes may change over time Macaroni and cheese Spinach Bell-bottoms

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Wants and Utility

Utility: the satisfaction people derive from consumption Well-being, happiness Measured indirectly

Subjective Observable

Cannot be compared between people Individual goal is to maximize utility

Allocate resources accordingly

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Sarah's Utility from Ice Cream

Cones / Hour

0 1 2 3 4 5 6

Total Utility 0 50 90 120 140 150 140

Cones/hour

Util

s/ho

ur

1 3 4 5 62

150140

120

90

50

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Sarah's Marginal Utility from Ice Cream

Marginal utility: the additional utility from consuming one more

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 = Change in utility

Change in consumption

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Law of Diminishing Marginal Utility

Tendency for additional utility gained

from consuming an additional unit of a good

to decrease as consumption increases

beyond some point

Diminishing Marginal Utility

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Diminishing Marginal Utility

Marginal utility can increase at low levels of consumption

Eventually marginal utility declines Apply Cost-Benefit Principle

Consume an additional unit as long as the marginal utility (benefit) is greater than the marginal cost

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Spending on Two Goods

Given a fixed budget, law of Diminishing Marginal Returns applies As you buy more of a

single good, its marginal utility decreases

When you buy less of that good, its marginal utility increases

Ma

rgin

al U

tility

Ma

rgin

al U

tilit

y

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The Rational Spending Rule

Spending should be allocated across goods so that

the marginal utility per dollar

is the same for each good

Rational Spending Rule

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Rational Spending Rule

Rational Spending Rule can be written algebraically Notation

MUC is the marginal utility from chocolate

MUV is the marginal utility from vanilla

PC is the price of chocolate

PV is the price of vanilla Rational Spending Rule

MUC / PC = MUV / PV

The marginal utility per dollar spent on chocolate equals the marginal utility per dollar spent on vanilla

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Budget Allocation

Given the budget, the utility is maximized when the marginal utility per dollar spent is the same for all goods Current spending has marginal utility of a dollar

spent on one good higher than the marginal utility of a dollar spent on the other good

Take a dollar away from the good with low marginal utility and spend it on the good with high marginal utility Marginal utilities per dollar begin to equalize

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Sarah's Ice Cream

$400 budget Chocolate is $2 per pint Vanilla is $1 per pint

Buy 200 pints of vanilla and 100 pints of chocolate Marginal utility is 12 for

vanilla, 16 for chocolate

Pints/yr

Vanilla Ice Cream

12

200

MU

(u

tils/

pin

t)

Chocolate Ice Cream

Pints/yr

16

100M

U

(util

s/ p

int)

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Sarah's ChoicesVanilla MU MU / $ TU

100 16 16 1600

150 14 14 2100

200 12 12 2400

250 10 10 2500300 7 7 2100

chocolate MU MU / $ TU 150 8 4 1200

125 12 6 1500

100 16 8 1600

75 20 10 1500

50 24 12 1200

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Sarah's Next Step

Increase vanilla by 100 Reduce chocolate by 50

Marginal utility of vanilla is 8

Marginal utility of chocolate is 24

Chocolate Ice Cream

Pints/yr

16

100M

U

(util

s/ p

int)

50

24

Pints/yr

Vanilla Ice Cream

200

MU

(u

tils/

pin

t)

300

812

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Sarah's Equilibrium Optimal combination:

highest total utility 250 pints vanilla; 75

pints chocolate

Marginal utility / price is the same for all goods Marginal utility of vanilla

10, chocolate 20

MU

(u

tils/

pin

t)

Pints/yr

Vanilla Ice Cream

250

10

MU

(u

tils/

pin

t)

Chocolate Ice Cream

Pints/yr

20

75

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Substitution Effect When the price of a good goes up,

substitutes for that good are relatively more attractive If the price of vanilla ice cream goes up, some

buyers will buy less vanilla and more chocolate

Income Effect Changes in price affect the buyers'

purchasing power

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Suppose price of vanilla increases from $1 to $2

At the original equilibrium

MUC / PC = MUV / PV

With the increase in PV, MUV / PV < MUC / PC

If Sarah buys more chocolate, MUC will go down

If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point,

Buy more chocolate. Buy less vanilla. Stop when the marginal utility per dollar is the same

At new price for vanilla, she buys 100 vanilla and only 100 chocolate

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Suppose Chocolate Ice Cream Price Goes Down from $2 to $1

With the decrease in Pc,

MUV / PV < MUC / PC

If Sarah buys more chocolate, MUC will go down

If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point,

Buy more chocolate, Buy less vanilla, Stop when marginal utility per dollar is the same

At new price for chocolate, she buys somewhere between 250 and 275 vanilla and somewhere between 125 and 150 chocolate.

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Eric's Apples

Apples Oranges

Total Expenditures

$100 $50

Price $2 $1

Total Utility 1,000 400

Quantity 50 50

Is Eric following the Rational Spending Rule?

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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

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Consumer Surplus

Consumer's surplus is the difference between the buyer's reservation price and the market price

With multiple buyers Find the consumer surplus for each buyer Add up the individual surpluses

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Consumer Surplus on a Graph

When a product is sold in whole units, the demand curve is a stair-step function Many goods are indivisible:

movie tickets and TVs 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

D

Units/day

Mar

gina

l util

ity

(util

s/ p

int)

12

34

5

6789

1011

12

2 4 6 8 10 12

Vanilla Ice Cream

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Consumer Surplus on a Graph 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 $6Selling 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

D

Units/day

Mar

gina

l util

ity

(util

s/ p

int)

12

345

67

89

1011

12

2 4 6 8 10 12

Vanilla Ice Cream

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Consumer Surplus for Milk

Consider the market demand and supply of milk

The equilibrium price is $2 per gallon

The equilibrium quantity is 4,000 gallons per day Last customer pays his

reservation price and gets no consumer surplus

Quantity (000s of gal/day)

Pric

e ($

/gal

lon)

1

1.00

2.00

3.00

2 3 4 5 6

S

D

Consumer Surplus