Demand: The Benefit Side of the Market

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Demand The Benefit Side of the Market
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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
• 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 wed be willing to pay

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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

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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

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Fig. 5.2 Total Utility from Ice Cream
Consumption
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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

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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

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Rational Spending Rule

• What should you do if MUc/Pc gt 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??

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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.

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Exercise 4 p 138

• Tobys 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?

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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.

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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

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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

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Fig. 5.4 Individual and Market Demand Curves
for Canned Tuna
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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

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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

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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
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Consumer Surplus
What is the optimal quantity to consume, and how
much is consumer surplus?
Q MB (demand) MC (P)
1 100 40
2 80 40
3 60 40
4 40 40
5 20 40
Q 4 units (MC MC) and CS 120