Demand: The Benefit Side of the Market

1. Demand: The Benefit Side of the Market

2. Law of Demand • Law of Demand • People do less of what they want to do as the cost of doing it rises • Recall the Cost-Benefit Principle • Pursue an action if and only if its benefits are at least as great as its costs • Recall the Reservation Price • The highest price we’d be willing to pay

3. Utility • Utility represents the satisfaction people derive from consumption activities • Utility Maximization refers to people trying and allocate their incomes to maximize their satisfaction • Normally, the more we consume, the more total utility we have (assumes goods are good) • At the margin however, incremental utility decreases in quantity – law of diminishing marginal utility

4. Marginal Utility • The additional utility gained from consuming an additional unit of the good • The movement from one quantity to the next • The Law of Diminishing Marginal Utility • As consumption of a good increases beyond some point, the additional utility gained from an additional unit of the good tends to decline • I.E., when the second good does not double our utility

5. Fig. 5.2 Total Utility from Ice Cream Consumption

6. Optimal Combination • When buying a variety of goods, how do we maximize total utility? • The optimal combination of goods to purchase is the affordable combination that yields the highest total utility

7. Rational Spending Rule • Suppose we are purchasing 2 goods: C and S • Spending should be allocated across goods so that the marginal utility per dollar (“bang-for-the- buck”) is the same for each good • the marginal utility per dollar = • The ratio of marginal utility to price must be the same for each good the consumer buys

8. Rational Spending Rule • What should you do if: MUc/Pc > MUs/Ps ? • E.g. you get 20 units of utility per dollar spent on C and only 16 units of utility per dollar spent on S. • You should buy more C and less S to increase total utility without spending any more money. • But, what happens when you do this??

9. Rational Spending Rule • As you buy more of the higher MU/P good its MU decreases (law of DMU). • As you buy less of the lower MU/P good its MU increases (law of DMU in reverse). • Eventually, the MU/P will be equal, and you cannot increase utility further by moving your dollars around.

10. Exercise #4 p 138 • Toby’s current marginal utility from consuming peanuts is 100 units of utility per once, and his marginal utility from cashews is 200 units of utility per once. The price of peanuts is 10 cents per once, and the price of cashews is 25 cents per once. • Is Toby maximizing his total utility from the consumption of these 2 goods?

11. Exercise #4 p 138 Peanuts: MU/$ = 100/.10 = 1000 Cashews: MU/$ = 200/.25 = 800 Peanuts yield higher marginal utility per dollar and are therefore a “better deal”. He should consumer more peanuts and less cashews to increase total utility.

12. Individual vs. Market Demand • How do we “add-up” the individual demands for all consumers in a market to form the market demand curve? • Option 1: add all prices and quantities • Option 2: add all prices at each quantity demanded • Option 3: add quantities demanded at each price

13. Individual vs. Market Demand • Option 3 is correct: to find the market quantity demanded at each price, simply add the individual quantities demanded • This should make sense, because consumers face the same set of prices, but have different quantities demanded. • This is called “horizontal summation” because we are adding along the horizontal (quantity) axis

14. Fig. 5.4 Individual and Market Demand Curves for Canned Tuna

15. Consumer Surplus • What happens when you purchase something for a price that is less than your maximum willingness to pay? • E.g. you are willing to pay $20,000 for a new car and you buy it for 18,000 • You receive a “surplus” of benefit over cost = $2,000

16. Consumer Surplus and Demand • Consumer surplus for a given quantity is therefore the difference between your maximum willingness to pay (reservation price) and what you actually paid (actual price). • CS = the sum of the difference between MB and MC (price) for all units consumed

17. Consumer Surplus and Demand • Graphically then, CS is the area above the price line and below the demand curve, up to Q* P 40 20 Here, CS = $200 =½(base)(height) = ½(20)(20) S D 20 Q

18. Consumer Surplus What is the optimal quantity to consume, and how much is consumer surplus? Q* = 4 units (MC =MC) and CS = $120