Demand: The Benefit Side of The Market

1
Demand The Benefit Side of The Market
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The Law of Demand

• People do less of what they want to do as the
  cost of doing it rises.
• The cost of an activity, good, or service
  involves not just monetary costs, but
  non-monetary costs as well.

Waiting in the line is a kind of nonmonetary
cost
3
Recall The Cost-Benefit Principle

• An individual (or a firm or a society) should
  take an action if, and only if, the extra
  benefits from taking the action are at least as
  great as the extra costs.
• Now, lets apply the Principle on analyzing
  consumer behaviour.

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The Law of Demand

• The benefit of an activity equals the highest
  price wed be willing to pay to pursue it (
  reservation price for consumers)
• The cost of an activity equals to the sum of
• i) monetary cost (i.e. market price) PLUS
• ii) non-monetary cost (e.g. time cost)

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The Law of Demand

• As the cost of an activity rises and exceeds the
  reservation price, less of the activity will be
  pursued.
• E.g. You will watch less movies when
• ? movie ticket price increases
• (monetary cost increases) OR
• ? Youll have a mid-term tomorrow (time cost
  increases)

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Law of Demand under a market context

• Demand curve for an individual consumer

In a market (for trading goods and services), the
price of a product refers to the market
price. according to his own demand curve,
individual chooses a purchasing plan under a
given/ prevailing market price
6
5
4
Price ( l b)
3
2
1
D
0
6
2
4
8
12
10
Quantity(lb/ week)
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e.g. 5.1 From Individual Demand Curves To Market
Demand Curve

• Suppose that there only two buyersSmith and
  Jonesin the market for apples, and that their
  demand curves are as shown in the following
  slide.
• To construct the market demand curve for apples,
  we simply announce a sequence of prices and then
  add the quantity demanded by each buyer at each
  price to obtain the total quantity demanded.
• Horizontal Summation

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e.g. 5.1 From Individual Demand Curves To Market
Demand Curve
Horizontal Summation
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Demand consumer surplus

• Consumer surplus the difference between a
  buyers reservation price for a product and the
  price actually paid.
• The term sometimes refers to the surplus received
  by a single buyer in a transaction, sometimes to
  denote the total surplus received by all buyers
  in a market or collection of markets.

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e.g. 5.2 Calculating CS discrete fn
hypothetical market for a good with 11 potential
buyers, each of whom can buy a maximum of one
unit of the good each day.
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11
10
9
8
7
Price (/unit)
6
5
4
3
2
1
1
2
3
4
5
6
7
8
9
10
11
12
0
Units/day
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e.g. 5.2 Calculating CS discrete fn
We rank all these buyers such that first
potential buyers reservation price for the
product is 11 the second buyers reservation
price is 10 the third buyers reservation price
is 9 and so on.
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11
10
9
8
7
Price (/unit)
6
5
4
3
2
1
1
2
3
4
5
6
7
8
9
10
11
12
0
Units/day
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e.g. 5.2 Calculating CS discrete fn
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Consumer surplus (11-6)(10-6)(9-6)(8-6)(7-
6) 15/day
11
10
9
8
If P6/unit, how many consumers will buy the
good?
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Price (/unit)
6
5
4
3
2
Demand
1
1
2
3
4
5
6
7
8
9
10
11
12
0
Units/day
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e.g. 5.3 Calculating CS continuous fn

• Question
• How much do buyers benefit from their visit to
  public swimming pools?

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e.g. 5.3 Calculating CS continuous fn

• height 1/visit
• base 4,000
• Consumer surplus
• (1/2)(4,000)(1)
• 2,000/week

Consumer surplus
S
3.00
2.50
Price (/ visit)
2.00
1.50
1.00
D
.50
1
2
3
4
5
6
7
8
9
10
11
12
0
Quantity (1,000s of visit/ week)
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e.g. 5.4 CS explains?

• What does Consumer Surplus explain in Economics?
• Suppose all public swimming pools are losing
  money and the LCSD decided to close all of them.
• To protest, citizens agreed to pay a fixed sum of
  money to buy out these swimming pools
• What will be the max. possible amount of this
  payment?

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e.g. 5.4 CS explains?

• What does Consumer Surplus explain in Economics?
• ? Consumer Surplus represents the max. amount of
  money consumers are willing to pay in acquiring
  the right to enter the market for the good in
  question.

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Consumer surplus

• What does Consumer Surplus explain in Economics?
• In reality, the following arrangements confirm
  the fact that buyers behaviour is not governed
  by market price solely
• e.g. membership fee for video rental/
• entrance fee for theme parks/
• peanuts/snacks fee for karaoke

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Translating Wants into Demand

• So much about CS, now well take a look at an
  econ model that analyze consumption choices based
  on the cost-benefit principle.
• How should we allocate our income among the
  various goods and services that are available?

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Translating Wants into Demand

• Consumption choices (purchase plan) on a 2 goods
  model (good x good y)
• Endogenous variable Qx and Qy
• Exogenous variable Px, Py and Budget (or
  income)
• Cost-benefit Analysis
• ? Cost Data Market prices
• ? Benefit Data Utility

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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.
• ? Objective Utility Maximization

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e.g. 5.5. Sams Total Utility from Dim Sum
Consumption
Assume TU takes an inverted U-shape
Utils
How many pieces of dim sum should Sam consume if
the dim sum is free?
0
1
3
4
5
6
2
Pieces
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e.g. 5.5. Sams Total Utility from Dim Sum
Consumption
Utils
The marginal utility from consuming a good is the
additional utility that results from consuming an
additional unit of the good.
0
1
3
4
2
1.5
0.5
2.5
4.5
3.5
pieces
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Diminishing Marginal Utility

• The law of diminishing marginal utility says that
  as consumption of a good increases beyond some
  point, the additional utility that results from
  an additional unit of the good declines.

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The Utility Model

• Analyze Consumption choices (purchase plan) on 2
  goods (good x good y)
• Endogenous variable Qx and Qy
• Exogenous variable Px, Py and Budget (
  income)
• Cost-benefit Analysis
• ? Cost Data Market prices
• ? Benefit Data Utility

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The Utility Model

• Target/ Assumed objective
• People allocate their income to maximize their
  total utility.
• Thus, the optimal combination of goods is that
  combination that yields the highest total utility
  among all the affordable combinations.

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e.g. 5.6 deriving optimal combinations on 2 goods

• Assume
• Two goods French Fries and milkshakes
• Price of French Fries 6/ pack
• Price of milkshakes 12/ pint
• Budget 30/ week
• How should Peter allocate his budget on these
  two goods in order to maximize his TOTAL Utility?

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e.g. 5.6 deriving optimal combinations on 2 goods

• Peters Total Utility from Fries and Milkshakes
  consumption

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e.g. 5.6 deriving optimal combinations on 2 goods

• First list all the combinations of fries and
  shakes that cost 30/wk, and then see which one
  delivers the highest total utility.
• P of fries 6/ pack P of milkshakes 12/ pint

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e.g. 5.7 optimal combination under continuous
utility fn

• Assume
• Two types of fruits Apples and Oranges
• Price of apple 8/ lb
• Price of oranges 4/ lb
• Budget 800/ yr on fruits for Susan

pistachio
Cashew
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e.g. 5.7 optimal combination under continuous
utility fn
P apple 8/ lb P orange 4/ lb Budget 800/ yr
Marginal utility of oranges (utils/ lb)
Marginal utility of apples (utils/ lb)
Lb /yr
Lb /yr
If Susan currently consumes 80 lbs of apples and
40 lbs of oranges, is she maximizing her TOTAL
utility?
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e.g. 5.7 optimal combination under continuous
utility fn
P apple 8/ lb P orange 4/ lb Budget 800/ yr
Marginal utility of oranges (utils/ lb)
Marginal utility of apples (utils/ lb)
Lb /yr
Step 1 Check if all income is spent. With 80
pounds per year of apples and 40 pounds of
oranges, Susan is spending her entire 800 annual
budget for fruits.
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e.g. 5.7 optimal combination under continuous
utility fn

• Step 2 Check marginal utility per dollar spent
  on the two goods.
• Her current spending on apples is yielding
• (20 utils/pound)/(8/pound) 2.5 utils per
  dollar.
• Her current spending on oranges is yielding
• (16 utils/pound)/(4/pound) 4 utils per
  dollar.

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e.g. 5.7 optimal combination under continuous
utility fn

• So her current spending yields higher marginal
  utility per dollar for oranges than for apples.
• If Susan moves a dollars expenditure from
  apple to oranges, she can achieve (4-2.5) 1.5
  utils in extra.
• i.e. current consumption level has not yet
  achieved max. utility

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e.g. 5.7 optimal combination under continuous
utility fn

• So Susan decided to buy more oranges and less
  apples
• She now decided to buy 70 lbs of apples and 60
  lbs of oranges per year
• Is she maximizing utility?

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e.g. 5.7 optimal combination under continuous
utility fn
apples
oranges
Her spending on apples now yields (28
utils/pound)/(8/pound) 3.5 utils per
dollar. Her spending on oranges now yields (8
utils/pound)/(4/pound) 2 utils per dollar.
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e.g. 5.7 optimal combination under continuous
utility fn

• So at her new rates of consumption of the two
  goods, her spending yields higher marginal
  utility per dollar for apples than for
  orangesprecisely the opposite of the previous
  case.
• Susan has thus made too big an adjustment in her
  effort to remedy her original consumption
  imbalance.
• Lets evaluate another consumption bundle

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e.g. 5.7 optimal combination under continuous
utility fn
apples
oranges
Now, Susan consumes 75 lbs of apples and 50 lbs
of oranges. At her current consumption levels,
marginal utility per dollar is (24
utils/lb)/(8/lb) (12 utils/lb)/(4/lb) 3
utils per dollar for each type of fruit.
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The Rational Spending Rule

• Spending should be allocated across goods so
  that the marginal utility per dollar is the same
  for each good in order to maximize the TOTAL
  utility under a given budget.

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The Rational Spending Rule for two goods, X and Y

• Suppose MUX/PX gt MUY/PY.
• Then you can increase total utility by spending a
  dollar less on Y and a dollar more on X.
• e.g. Suppose MUX/PX 3 gt MUY/PY 2.
• ? Then by spending a dollar less on Y (lose 2
  utils) and a dollar more on X (gain 3 utils) you
  can achieve a net gain of 1 util for the same
  expenditure.

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The Rational Spending Rule

• How is the rational spending rule related to the
  substitution and income effects? (taught in Ch.
  3)
• Given an original equilibrium MUx/Px MUy/
  Py
• When Px increases, how would you respond to
  the consumption of X? consumption of Y?

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e.g. 5.8. Why do Japanese live in smaller houses
than Americans?
Why do people in the city live in smaller
houses/apartments than those in the country side?
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e.g. 5.8. Why do Japanese live in smaller houses
than Americans?

• Cultural differences?
• Yes, but why these cultural differences?
• The differences are a simple consequence of the
  law of demand. Market price of all land in Japan
  exceeds the market price of all land in North and
  South America and Western Europe combined.
• Rational Japanese consumers respond by buying
  smaller houses.

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e.g. 5.9

• Why do highly industrialized countries typically
  have less environmental pollution than less
  highly industrialized countries?

Less industrialized countries (e.g., Mexico)
Industrialized countries (e.g., United States)
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e.g. 5.9

• Although industrial processes themselves are
  often the source of environmental pollution
  itself,
• the more industrialized a country is, the higher
  income its citizens enjoy.
• the higher income people have, the more they are
  willing to spend on equipment and processes that
  reduce environmental pollution.

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e.g. 5.10

• The importance of Income Differences
• Why has the price of premium wine risen more
  rapidly than the average price of wine in most
  countries?

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e.g. 5.10

• Wealthy people tend to buy fine wines people of
  average incomes tend to buy wines of average
  quality.
• Incomes of the top 1 percent of earners have
  grown much faster than median earnings over the
  last 20 years.
• So demand for wines of average quality has
  remained stable while demand for premium quality
  wines has increased.

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End of Chapter