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Econ 2610: Principles of Microeconomics

Econ 2610: Principles of Microeconomics. Yogesh Uppal Email: yuppal@ysu.edu. Chapter 5. Demand. 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

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Econ 2610: Principles of Microeconomics

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  1. Econ 2610: Principles of Microeconomics Yogesh Uppal Email: yuppal@ysu.edu

  2. Chapter 5 Demand

  3. 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

  4. Law of Demand Law of DemandPeople do less of what they want to do as the cost of doing it rises

  5. Cost-Benefit Principle at work • 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

  6. 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

  7. 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

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

  9. Sarah's Marginal Utility from Ice Cream Change in utility Marginal utility = Change in consumption Marginal utility: the additional utility from consuming one more

  10. Diminishing Marginal Utility 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

  11. 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

  12. Spending on Two Goods Marginal Utility Marginal Utility • 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

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

  14. 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

  15. 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

  16. Sarah's Ice Cream Vanilla Ice Cream Chocolate Ice Cream MU (utils/ pint) MU (utils/ pint) 16 12 200 100 Pints/yr Pints/yr • $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

  17. Sarah's Choices

  18. Sarah's Next Step Vanilla Ice Cream Chocolate Ice Cream 24 MU (utils/ pint) MU (utils/ pint) 16 12 8 300 200 50 100 Pints/yr Pints/yr Marginal utility of vanilla is 8 Marginal utility of chocolate is 24 • Increase vanilla by 100 • Reduce chocolate by 50

  19. Sarah's Equilibrium Vanilla Ice Cream Chocolate Ice Cream 20 MU (utils/ pint) MU (utils/ pint) 10 75 250 Pints/yr Pints/yr 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

  20. Substitution Effect Income Effect • Changes in price affect the buyers' purchasing power • 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

  21. 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

  22. 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.

  23. Eric's Apples • Is Eric following the Rational Spending Rule?

  24. 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

  25. 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

  26. Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 9 8 7 Marginal utility (utils/ pint) 6 5 4 3 2 D 1 2 4 6 8 10 12 Units/day • 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

  27. Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 9 8 7 Marginal utility (utils/ pint) 6 5 4 3 2 D 1 2 4 6 8 10 12 Units/day • 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 $6 • Selling 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

  28. Consumer Surplus for Milk Consumer Surplus S 3.00 2.00 Price ($/gallon) D 1.00 1 2 3 4 5 6 Quantity (000s of gal/day) • 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

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