Lecture 1 Demand and willingness to pay Microeconomics 1000 Lecture 1 Demand and willingness to pay

Teacher Vincenzo Denicolò Room 104, Astley Clarke Building E-mail address: vd51@le.ac.uk Office hours: Thursdays 2p.m. – 4 p.m.

Timetable (but check course web page for possible changes!) Week starting on Wednesday 11a.m. Thursday 11a.m. Friday 10a.m. 2 (Oct. 10th) X 3 (Oct. 17th) 4 (Oct. 24th) 5 (Oct. 31st) 6 (Nov. 7th) 7 (Nov. 14th ) 8 (Nov. 21st) No lectures this week 9 (Nov. 28th) 10 (Dec. 5th) 11 (Dec. 12th) Copyright © 2004 South-Western

Exam 30 multiple choice questions 1 essay (to be chosen out of 4 titles)

Classes and Tutorials Staring from week 3 (the next week) you will have to attend also classes and tutorials Classes discuss multiple choice questions Tutorials will cover more complex exercises

Textbook N Gregory Mankiw and Mark P. Taylor, Economics, 2010, South-Western Cengage Learning. ISBN 978 1 4080 2126 2 Website: http://www.cengage.co.uk/mankiw_taylor_special chapters 1-2 are introductory chapters that should be read before the course starts Exercise 1 serves as a review of this preliminary material

Alternative textbook Paul Krugman and Robin Wellas, Economics, 2009, Worth Publishers (or the Microeconomics only version)

Microeconomics… Typical microeconomic issues Strategic behaviour of firms (e.g., why did Microsoft decide to bundle Windows and Internet Explorer?) Determinants of the demand for specific goods (e.g., why has health expenditure been increasing over time?) Effect of specific taxes (e.g., why is alcohol generally taxed more heavily than milk, and what effect does this have on alcohol consumption?)

And Macroeconomics (II semester) Typical macroeconomic issues: Why is UK per capita income today ten times as large as in 1850? Why is UK per capita income ten times as large as Bolivia’s? What determines the inflation rate? What are the consequences of large fiscal deficits?

That is: Microeconomics studies the behaviour of single economic agents (firms, consumers), and the way in which they interact in the market place Macroeconomics studies the behaviour of aggregate variables (national income, the average level of prices, imports and exports)

Market economy Our main aim is to understand how a market economy works In a market economy, the allocation of resources (in other words, who does what and who gets what) is determined by the market

A few definitions Market: the set of trades concerning a particular good Equilibrium: a situation in which no economic agent would want to change his or her behaviour, even if he or she is given the opportunity to Efficiency: the property of not being further susceptible of improvement

Demand and willingness to pay We start from the case of an indivisible good To begin with, we further assume that the buyer wants at most one unit of it (e.g., a movie, or an economic textbook) The willingness to pay is the maximum amount of money the buyer is willing to pay

Wtp and price Note: in general, w.t.p. ≠ price, which is what the buyer actually pays (if he purchases the good) We shall denote wtp by the letter v, and price by the letter p Thus, v ≠ p However, for a rational buyer who purchases the good, we can be sure that v ≥ p

What determines wtp? There are two main determinants of the wtp of a buyer for a good: His preferences His income These will be studied in greater detail in Lecture 15

Uses of wtp Two uses of the w.t.p. To assess the value of the good to the buyer, and hence how much he gains from trade To determine buyer’s behaviour (i.e. his demand for the good)

Gains from trade The buyer’s benefit from trade is v – p; this is called consumer surplus or consumer rent The implicit assumption is that the w.t.p. is a good measure of the value of the good to the consumer However, recall that the w.t.p. depends also on the consumer’s income

Demand If the buyer is rational, he will demand (that is, he is willing to purchase) the good if and only if p ≤ v (if p = v the buyer is actually indifferent between purchasing or not)

Demand schedule Now imagine that there are several potential buyers (e.g., A, B, C and D) with different w.t.p.’s, vA, vB, vC and vD If necessary, rename buyers so that vA ≥ vB ≥ vC ≥ vD Suppose all buyers behave rationally

price vA Consumer rent: 20 – 17 = 3 20 17 p vB 12 vC 8 vD 3 O quantity 1 2 3 4

price vA Consumer rent: (20 – 5) + (12 – 5) + (8 – 5) = 25 20 vB 12 vC 8 p 5 vD 3 O quantity 1 2 3 4

price With a large number of buyers, we can approximate the demand schedule by a smooth curve, the demand curve quantity

Summary The demand schedule is a table that represents for each value of the price the total quantity consumers are willing to purchase at that price The demand function is the relation between quantity and price The demand curve represents the demand function (notice that the dependent variable, quantity, is represented on the horizontal axis, contrary to standard mathematical convention)

Summary If the price goes down Demand goes up (the number of consumers i such that vi ≥ p can only increase, or at most stay constant, if p decreases) Consumer surplus goes up (more consumers are served, and each of them gains more from trade)

Many units Assume again that the good is indivisible, but now suppose the consumer may consume more than one unit (e.g., shirts) Successive units may be seen as separate goods Let v(n) denote the total w.t.p. for n units Then, v(n) – v(n – 1) is the willingness to pay for the nth unit (the marginal willingness to pay)

Optimal consumption Assumption: the marginal w.t.p. is decreasing in n Assumption (rationality): the consumer chooses n so as to maximise his net benefit from trade, v(n) – n×p Optimal behavioural rule: consume one more unit as long as marginal w.t.p. ≥ price

Example Suppose v(1) = 20 v(2) = 32 so v(2) – v(1) = 12 We obtain exactly the same demand schedule as in our original example with four different consumers

Figure 1 Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of 2. ... increases quantity of cones demanded. Ice-Cream Cones Copyright © 2004 South-Western