MBMC Demand: The Benefit Side of The Market

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 2 The Law of Demand People do less of what they want to do as the cost of doing it rises

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 3 The 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 4 The Law of Demand The Origins of Demand What determines “tastes” or “preferences”?  Biology  Culture  Peer Influences

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 5 The Law of Demand Economic Naturalist Needs vs. Wants  Why does California experience chronic water shortages?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 6 Translating Wants into Demand How should we allocate our incomes among the various goods and services that are available?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 7 Translating Wants into Demand 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 8 Sarah’s Total Utility from Ice Cream Consumption Cone quantity (cones/hour) Total utility (utils/hour) How much ice cream should Sarah consume if the ice cream is “free”?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 9 Sarah’s Total Utility from Ice Cream Consumption Cones/hour Utils/hour

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 10 Translating Wants Into Demand What should Sarah do when she gets to the front of the line? What do you think? Is the time spent in the line relevant to how many cones to order?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 11 Sarah’s Total Utility and Marginal Utility from Ice Cream Consumption Cone quantity Total utilityMarginal utility (cones/hour) (utils/hour)(utils/cone) __

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 12 Sarah’s marginal utility Diminishing Marginal Utility Cones/hour Utils/cone

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 13 Translating Wants into Demand 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 14 Translating Wants into Demand Allocating A Fixed Income Between Two Goods Assume  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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 15 Translating Wants into Demand Question Is Sarah maximizing her total utility?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 16 Marginal Utility Curves for Two Flavors of Ice Cream (I) Pints/yr Marginal utility of vanilla ice cream (utils/ pint) Marginal utility of chocolate ice cream (utils/ pint) Pints/yr

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 17 Translating Wants into Demand Marginal utility vanilla/P $12/1 = 12 utils/$ Marginal utility chocolate/P 16/2 = 8 utils/$

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 18 Translating Wants into Demand 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 19 Marginal Utility Curves for Two Flavors of Ice Cream (II) Pints/yr Marginal utility of vanilla ice cream (utils/ pint) Sarah increases vanilla spending by $100, and MU V /P V = 8/$1 = 8

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 20 Marginal Utility Curves for Two Flavors of Ice Cream (II) Marginal utility of chocolate ice cream (utils/ pint) Pints/yr Sarah decreases chocolate spending by $100, and MU C /P C = 24/$2 = 12 > MU V /p V = 8

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 21 Marginal Utility Curves for Two Flavors of Ice Cream (III) Pints/yr Marginal utility of vanilla ice cream (utils/ pint)

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 22 Marginal Utility Curves for Two Flavors of Ice Cream (III) Marginal utility of chocolate ice cream (utils/ pint) Pints/yr 20 75

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 23 Translating Wants into Demand The Rational Spending Rule Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 24 Translating Wants into Demand The Rational Spending Rule How is the rational spending rule related to the cost-benefit principle?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 25 Translating Wants into Demand Income and Substitution Effects Revisited How should Sarah respond to a reduction in the price of chocolate ice cream?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 26 Marginal Utility Curves for Two Flavors of Ice Cream (III) Pints/yr Marginal utility of vanilla ice cream (utils/ pint) Marginal utility of chocolate ice cream (utils/ pint) Pints/yr

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 27 Translating Wants into Demand Assume Budget = $400 P C = $2 & P V = $1 Q C = 75 & Q V = 250

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 28 Translating Wants into Demand Assume Price of chocolate falls to $1

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 29 Applying the Rational Spending Rule Economic Naturalist Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 30 Applying the Rational Spending Rule Economic Naturalist Why did people turn to four-cylinder cars in the 1970s only to shift back to six- and eight-cylinder cars in the 1990s?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 31 Applying the Rational Spending Rule Economic Naturalist Why are automobile engines smaller in England than in the United States?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 32 Applying the Rational Spending Rule The Importance of Income Differences Why are waiting lines longer in poorer neighborhoods?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 33 Individual and Market Demand Curves for Canned Tuna Price ($/can) Smith’s quantity (cans/week) 248 Price ($/can) Jones’s quantity 6 0 (cans/week) 24 Smith Jones + Horizontal Addition

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 34 Individual and Market Demand Curves for Canned Tuna Price ($/can) Total quantity 6 0 (cans/week) = Market Demand curve

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 35 The Individual and Market Demand Curves When All Buyers Have Identical Demand Curves Price ($/can) Quantity (cans/month) D Quantity (1000s of cans/month) D Price ($/can) Each of 1,000 consumers have the same demand Market Demand = P x number of consumers (1,000)

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 36 Demand and Consumer Surplus Consumer Surplus The difference between a buyer’s reservation price for a product and the price actually paid

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 37 Demand A Market with a “Digital” Demand Curve Units/day Marginal utility of vanilla ice cream (utils/ pint)

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 38 Consumer Surplus Units/day Marginal utility of vanilla ice cream (utils/ pint) Demand 0 Consumer surplus = $15/day

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 39 Demand and Consumer Surplus Question How much do buyers benefit from their participation in the market for milk?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 40 Supply and Demand in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) S D

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 41 Consumer Surplus in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) S D Consumer surplus h = $1/gallon b = 4,000 Consumer surplus = (1/2)(4,000)(1) = $2,000/day

MBMC End of Chapter End of Chapter