Frank & Bernanke 3 rd edition, 2007

1. Frank & Bernanke3rd edition, 2007 Ch. 5: Demand - The Benefit Side of The Market

2. 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?

3. 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.”

4. 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.

5. 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!”

6. 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

7. Sarah’s Total Utility from Ice Cream Consumption Cone quantity (cones/hour) Total utility (utils/hour) 0 0 1 50 2 90 3 120 4 140 5 150 6 140 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?

8. 150 140 120 90 50 Sarah’s Total Utility from Ice Cream Consumption Utils/hour 0 1 2 3 4 5 6 Cones/hour

9. Sarah’s Marginal Utility from Ice Cream Consumption Cone quantity Total utility Marginal utility (cones/hour) (utils/hour) (utils/cone) 0 0 1 50 2 90 3 120 4 140 5 150 6 140 50 40 30 20 10 -10

10. 50 Sarah’s marginal utility 40 30 20 10 Diminishing Marginal Utility 0 1.5 2 2.5 3 3.5 4 4.5 0.5 1

11. 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

12. 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

13. 16 12 200 100 Marginal Utility Curves for Two Flavors of Ice Cream Marginal utility of chocolate ice cream (utils/ pint) Marginal utility of vanilla ice cream (utils/ pint) Pints/yr Pints/yr

14. 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.

15. 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.

16. Sarah increases vanilla spending by $100, and MUV/PV = 8/$1 = 8 12 8 200 300 Vanilla Marginal utility of vanilla ice cream (utils/ pint) Pints/yr

17. Sarah decreases chocolate spending by $100, and MUC/PC = 24/$2 = 12 > MUV/pV = 8 24 16 50 100 Chocolate Marginal utility of chocolate ice cream (utils/ pint) Pints/yr

18. 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.

19. Equilibrium Marginal utility of vanilla ice cream (utils/ pint) 10 250 Pints/yr

20. Equilibrium 20 Marginal utility of chocolate ice cream (utils/ pint) 75 Pints/yr

21. Equilibrium • Budget = $400 • PC = $2 & PV = $1 • QC= 75 & QV = 250

22. The Rational Spending Rule • Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

23. Price of chocolate falls to $1

24. Applying theRational 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?

25. Individual and Market Demand Curves for Canned Tuna Horizontal Addition 1.60 1.60 1.40 1.40 1.20 1.20 1.00 1.00 Price ($/can) Price ($/can) .80 .80 .60 .60 + .40 .40 Smith Jones .20 .20 0 0 2 4 6 2 4 6 8 Jones’s quantity Smith’s quantity (cans/week) (cans/week)

26. Individual and Market Demand Curves for Canned Tuna 1.60 1.40 1.20 1.00 Price ($/can) .80 Market Demand curve .60 = .40 .20 0 2 4 6 8 10 12 Total quantity (cans/week)

27. D The Individual and Market Demand Curves When All Buyers Have Identical Demand Curves • Each of 1,000 consumers have the same demand • Market Demand = P x number of consumers (1,000) 6 6 5 5 4 4 Price ($/can) Price ($/can) 3 3 2 2 1 1 D 0 0 2 4 6 8 10 12 2 4 6 8 10 12 Quantity Quantity (cans/month) (1000s of cans/month)

28. Consumer Surplus • The difference between a buyer’s reservation price for a product and the price actually paid. P

29. S D Supply and Demand in the Market for Milk 3.00 2.50 Price ($/gallon) 2.00 1.50 1.00 .50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity (1,000s of gallons/day)

30. Consumer Surplus in the Market for Milk • h = $1/gallon • b = 4,000 • Consumer surplus = • (1/2)(4,000)(1) = • $2,000/day Consumer surplus S 3.00 2.50 Price ($/gallon) 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)