Chapter 5 Demand: The Benefit Side of the Market

Chapter 5 Demand: The Benefit Side of the Market odd-number Questions

Problem #1, Chapter 5 • In which type of restaurant do you expect the service to be more prompt and courteous: an expensive gourmet restaurant or an inexpensive diner? Explain.

Solution to Problem #1 (1) • Refer to chapter 1 • We discussed that the amount you are willing to spend on a certain product reveals the value or the benefit of the product • If you are rational and are willing to pay $800 for an admission ticket to watch a concert, the value or benefit of the concert must be at least $800 • In the question, two options are given: an expensive gourmet restaurant and an inexpensive diner • Both the restaurant and the diner are actually businesses selling food and services

Solution to Problem #1 (2) • In of terms of Economics goods, is “food” a normal good or an inferior good? • Food is both a necessity and a normal good. If your income increases, you will probably increase your consumption in food or increase your consumption in expensive food like premium beef and seafood • In of terms of Economics goods, is “service” a normal good or an inferior good? • Service is also a normal good. If your income increases, you will probably spend more on service or spend more on expensive service like hiring a in-house maid to do all the housework or hiring an professional accountant to look over your wealth management

Solution to Problem #1 (3) • Thus, “Willingness to pay for FOOD”, and that for SERVICE are increasing functions with income • Expensive gourmet restaurants like those in ifc or in luxurious hotels target on diners who earn higher incomes • Inexpensive diners like those on campus target on diners who earn lower incomes

Solution to Problem #1 (4) • To attract diners earning higher incomes and charge them a higher price, expensive gourmet restaurants provide high quality of food as well as high quality of service • To attract diners earning lower incomes and charge them a lower price, inexpensive diners provide low quality of food as well as low quality of service (self-serve on campus)

Problem #3, Chapter 5 • Martha’s current marginal utility from consuming orange juice is 75 utils per ounce and her marginal utility from consuming coffee is 50 utils per ounce. If orange juice costs 25 cents per ounce and coffee costs 20 cents per ounce, is Martha maximizing her total utility from the two beverages? If so, explain how you know. If not, how should she rearrange her spending?

Solution to Problem #3 (1) • Notion of marginal utility • The extra (additional) satisfaction one derives from one’s consumption activities • Thus, we can draw a parallel line between marginal utility and marginal benefit • We can solve this problem by applying the Rational Spending Rule: • Spending should be allocated across goods so that the marginal utility per dollar is the same for each good

Solution to Problem #3 (2) • Currently, • The marginal utility from drinking orange juice per dollar • = Marginal utility from consuming orange juice / Price per ounce • = 75 utils / $0.25 • = 300 utils per dollar from her last dollar spent on orange juice • The marginal utility from drinking coffee per dollar • = Marginal utility from consuming coffee / Price per ounce • = 50 utils / $0.20 • = 250 utils per dollar from her last dollar spent on coffee

Solution to Problem #3 (3) • As the marginal utilities from consuming orange juice and coffee are not the same, Martha has not maximized her total utility from drinking orange juice and coffee • To improve her total utility from consuming orange juice and coffee, Martha should drink more orange juice and less coffee • Why? • Drinking more orange juice will drive down the marginal utility from consuming orange juice per dollar • Drinking less coffee will drive up the marginal utility from consuming coffee per dollar • Note utility is a decreasing function with consumption

Problem #5, Chapter 5 • Sue gets a total of 20 utils per week from her consumption of pizza and a total of 40 utils per week from her consumption of yogurt. The price of pizza is $1 per slice, the price of yogurt is $1 per cup, and she consumes 10 slices of pizza and 20 cups of yogurt each week. • True and false: Sue is consuming the optimalcombination of pizza and yogurt.

Solution to Problem #5 (1) • False • To prove whether Ann is consuming an optimal combination of pizza and yogurt, we need to check whether the Rational Spending Rule holds in her case • Rational Spending Rule holds if the marginal utilities per dollar from the consumptive activities are the same • Unlike Problem #3 in which marginal utilities of consumptive activities are given, Problem #5 provides total utilities of consumptive activities • Thus, we can only come out with the average utilities per dollar from consuming pizza and yogurt

Problem #7, Chapter 5 • For the demand curve shown, find the total amount of consumer surplus that results in the gasoline market if gasoline sells for $2 per gallon 10 Price ($/gallon) 2 80 100 1,000s of gallons/yr

Solution to Problem #7 (1) • Reservation price refers to the maximum price that one will pay to buy a certain • Consumer surplus refers to the difference between a buyer’s reservation price for a product and the price actually paid • For example, I am willing to pay $30 for a Ham and cheese source sandwich sold at Starbucks for which it is sold for only $20 • My reservation price is $30 • The actual price I have to pay is $20 • Consumer surplus = $30 - $20 = $10

Solution to Problem #7 (2) • If we keep calculating the consumer surplus in such a way that one’s reservation price minus the actual market price of gasoline ($2), we will get a total consumer surplus that is equal to the area under the demand curve but above the actual price ($2) • Consumer surplus when the gasoline is $2 per gallon • = ($10-$2) * 800,000 gallons * (1/2) = $320,000 • Consumer surplus when the gasoline is $0 per gallon • = ($10-$0) * 100,000 gallons * (1/2) = $5,000,000

Solution to Problem #7 (3) • Consumer’s surplus • The area under the demand curve but above the actual market price • It is a triangle under a linear demand curve

Problem #9, Chapter 5 • Refer to Problem #8. Tom’s total utility is the sum of the utility he derives from pizza and movie rentals. If these utilities vary with the amounts consumed as shown in the table, and pizzas and movie rentals are again consumable only in whole-number amounts, how many pizzas and how many movie rentals should Tom consume each week?

Solution to Problem #9 (1) • To find the optimal combination of consumption in pizzas and movie rentals, we need to calculate the total utility of each possible combination of consumption on the two goods • That is, the optimal combination yields the highest total utility among all the affordable combinations.

Solution to Problem #9 (2) • Based on the above table, Tom should consume 3 slices of pizza and 2 movie rentals per week, as this is the optimal combination yielding the maximum total utility (100)

Chapter 5 Demand: The Benefit Side of the Market