1 Introductory Microeconomics Demand: The Benefit Side of the Market

2 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. Should I do activity x? C(x) = the costs of doing x B(x) = the benefits of doing x If ES(x) = B(x) - C(x) > 0, do x; otherwise don't. Example of x: consuming an additional unit of sushi.

4 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. Our “tastes” or “preferences”, and income determine our benefit. How is “tastes” or “preferences” determined? Biology Culture Peer Influences

5 Translating Wants into Demand How should we allocate our incomes among the various goods and services that are available?

6 Recall Rules for allocating resources The general rule for allocating a resource efficiently across different production activities is: Allocate each unit of the resource to the production activity where its marginal benefit is highest. For a resource that is perfectly divisible, and for activities for which the marginal product of the resource is not always higher in one than in the others, the rule is: Allocate the resource so that its marginal benefit is the same in every activity.

7 Measuring Wants: The Concept of Utility Utility The satisfaction people derive from their consumption activities Assumption (rationality) People allocate their income to maximize their satisfaction or total utility.

8 Example 5.1. Taiji’s Total Utility from Sushi Consumption Pieces of sushi /hour Utils/hour Pieces /hrTotal U /hr How many pieces of sushi should Taiji consume if the sushi is “free”?

9 Example 5.2. Taiji has been waiting outside a sushi shop for an hour. Now he is in the front of the line. He decides to consume 20 pieces of sushi at the price of $10 each. If Taiji has been waiting outside for two hours, should he consume more of sushi at the same price?

10 Example 5.3. Taiji’s Marginal Utility from Sushi Consumption PiecesTotal UMarginal U The marginal utility from consuming a good is the additional utility that results from consuming an additional unit of the good. Taiji’s marginal utility pieces/hour Utils/cone

11 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. Exceptions to the law of diminishing marginal utility: The unfamiliar food or melody.

12 The optimal combination of goods The optimal combination of goods is that combination that yields the highest total utility among all the affordable combinations. Assumption (rationality) People allocate their income to maximize their satisfaction or total utility.

13 Example 5.4. How many ostrich burgers should Tom consume each week and how many mango milkshakes? Tom derives all of his nourishment from only two foods: ostrich burgers and mango milkshakes. Ostrich burgers cost $8 per pound and mango milkshakes cost $4 per pint. If Tom has $20 per week to spend on food, what combination of the two should he eat? burgers (lb./wk)Utils/wk from burgersShakes (pints/wk)Utils/wk from shakes

14 Method 1. First list all the combinations of burgers and shakes that cost $20/wk, and then see which one delivers the highest total utility. Ostrich burgers cost $8 per pound and mango milkshakes cost $4 per pint. Combinations that cost $20/wkTotal Utility 2.5 lb. of burger, 0 pint of milkshake =23 2 lb. of burger, 1 pints of milkshake = lb. of burger, 2 pints of milkshake =50 1 lb. of burger, 3 pints of milkshake = lb. of burger, 4 pints of milkshake =43 0 lb. of burger, 5 pints of milkshake =33

15 Method 2. To achieve the highest possible utility from a given expenditure, divide your purchases among goods so that the marginal utility of the last dollar spent on each good is as large as possible.

16 Method 2. burgers (lb./wk) Utils/wk from burgers MU/$Shakes (pints/wk) Utils/wk from shakes MU/$ Ostrich burgers cost $8 per pound and mango milkshakes cost $4 per pint. Tom has $20 per week to spend on food.

17 Exercise Everything the same as Example But Ostrich burgers cost $8 per pound and mango milkshakes cost $8 per pint. Observe how the quantity demanded changes with price, for both goods.

18 Rational Spending Rule When the quantity of each good can be varied continuously, we have The Rational Spending Rule: Spending should be allocated across goods so that the marginal utility per dollar is the same for each good. Recall the rule of allocating resources. For a resource that is perfectly divisible, and for activities for which the marginal product of the resource is not always higher in one than in the others, the rule is: Allocate the resource so that its marginal benefit is the same in every activity. MU 1 /P 1 = MU 2 /P 2

19 Example 5.5. Is Sue maximizing her utility from consuming cashews and pistachios? Cashew nuts sell for $8 per pound and pistachios sell for $4 per pound. Sue has a budget of $800 per year to spend on nuts, and her marginal utility from consuming each type of nut varies with the amount consumed as shown on the next slide. If she is currently buying 80 pounds of cashews and 40 pounds of pistachios each year, is she maximizing her utility? Cashew pistachio

20 Example 5.5. Is Sue maximizing her utility from consuming cashews and pistachios? Step 1: Check if all income is spent. With 80 pounds per year of cashews and 40 pounds of pistachios, Sue is spending her entire $800 annual budget for nuts.

21 Example 5.5. Is Sue maximizing her utility from consuming cashews and pistachios? Step 2: Check marginal utility per dollar spent on the two goods. Her current spending on cashews is yielding (20 utils/pound)/($8/pound) = 2.5 utils per dollar. Her current spending on pistachios is yielding (16 utils/pound)/($4/pound) = 4 utils per dollar.

22 Example 5.5. Is Sue maximizing her utility from consuming cashews and pistachios? So her current spending yields higher marginal utility per dollar for pistachios than for cashews. And this means that Sue cannot possibly be maximizing her total utility.

23 Example 5.6. Is Sue maximizing her utility from consuming cashews and pistachios (II)? Sue’s total nut budget and the prices of the two types are the same as in Example 5.5. If her marginal utility from consuming each type varies with the amount consumed as shown in the next slide and if she is currently buying 70 pounds of cashews and 60 pounds of pistachios each year, is she maximizing her utility?

24 Example 5.6. Is Sue maximizing her utility from consuming cashews and pistachios (II)? The direction of Sue’s rearrangement of her spending makes sense in light of Example 5.5, in which we saw that she was spending too much on cashews and too little on pistachios. Her spending on cashews now yields (28 utils/pound)/($8/pound) = 3.5 utils per dollar. Her spending on pistachios now yields (8 utils/pound)/($4/pound) = 2 utils per dollar.

25 Example 5.6. Is Sue maximizing her utility from consuming cashews and pistachios (II)? So at her new rates of consumption of the two types of nuts, her spending yields higher marginal utility per dollar for cashews than for pistachios—precisely the opposite of the ordering we saw in Example 5.5. Sue has thus made too big an adjustment in her effort to remedy her original consumption imbalance.

26 Example 5.7. Is Sue maximizing her utility from consuming cashews and pistachios (III)? Sue’s total nut budget and the prices of the two flavors are again as in Examples 5.5 and 5.6. If her marginal utility from consuming each type varies with the amounts consumed as shown in the next slide and if she is currently buying 50 pounds of pistachios each year and 75 pounds of cashews each year, is she maximizing her utility?

27 Example 5.7. Is Sue maximizing her utility from consuming cashews and pistachios (III)? This time Sue has it just right. 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 nut.

28 The Rational Spending Rule for two goods, X and Y: MU X /P X = MU Y /P Y. Suppose MU X /P X > MU Y /P Y. Then you can increase total utility by spending a dollar less on Y and a dollar more on X. Suppose MU X /P X = 3 > MU Y /P Y = 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.

29 The Rational Spending Rule for N goods: MU 1 /P 1 = MU 2 /P 2 =... = MU N /P N.

30 Law of demand Substitution is the most important reason for the law of demand. When the price of something rises, we turn to substitutes.

31 Example: When the price of energy rises … We buy hybrid cars …

32 Example: When the price of energy rises … … take public transportation …

33 Example: When the price of energy rises … … move closer to work …

34 Example: When the price of energy rises … … buy more efficient appliances …

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

36 Example 5.8. Why do the Japanese live in smaller houses than the 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 (about the area of California) exceeds the market price of all land in North and South America and Western Europe combined. Rational Japanese consumers respond by buying smaller houses.

37 Example 5.9. Why this difference? In the U.S., gravel for road building is made by enormous machines that crush boulders into smaller stones. In Nepal, gravel is made by workers who hammer rocks into smaller stones. It has nothing to do with the fact that Nepal is “too poor” to afford the machines used in the U.S. The price of labor in Nepal is low relative to the price of capital, whereas the price of labor in the US is high relative to the price of capital.

38 Example Why do highly industrialized countries typically have less environmental pollution than less highly industrialized countries? Industrialized countries (e.g., United States) Less industrialized countries (e.g., Mexico)

39 Example It might seem more natural to expect the opposite relationship, since industrial processes themselves are often the source of environmental pollution. But more the more highly industrialized a country is, the higher its income typically is. And the more income people have, the more they are willing to spend on equipment and processes that reduce environmental pollution. Environmental Kuznet curve Dinda, Soumyananda (2004): “Environmental Kuznets Curve Hypothesis: A Survey,” Ecological Economics, 49(4):

40 Example Why has the price of premium wine risen more rapidly than the average price of wine? 1999 Domaine Romanée Conti: $5,200 $6.99 $7.99

41 Example Why has the price of premium wine risen more rapidly than the average price of wine? 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 tripled in real terms since 1979, a period during which median earnings grew only 15 percent. So demand for wines of average quality has remained stable while demand for premium quality wines has increased.

42 Adding Individual Demand Curves To Get Market Demand Curves (Horizontal Addition) Suppose that there only two buyers—Smith and Jones— in the market for cashews, and that their demand curves are as shown in the following slide. To construct the market demand curve for cashews, 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.

43 Adding Individual Demand Curves To Get Market Demand Curves (Horizontal Addition)

44 Demand and consumer surplus Consumer surplus: the difference between a buyer’s 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.

45 Example Calculating Consumer Surplus The demand curve in the following slide depicts a hypothetical market for a good with 11 potential buyers, each of whom can buy a maximum of one unit of the good each day. The first potential buyer’s reservation price for the product is $22; the second buyer’s reservation price is $20; the third buyer’s reservation price is $18; and so on.

46 Example Calculating Consumer Surplus Suppose this good were available at a price of $12 per unit. How much total consumer surplus would buyers in this market reap?

47 Example How much do buyers benefit from their participation in this market for cashews?

48 Example How much do buyers benefit from their participation in this market for cashews? The last unit exchanged each day generates no consumer surplus at all. For all cashews sold up to 4,000 pounds per day, buyers receive consumer surplus. Consumer surplus is the cumulative difference between the most they would be willing to pay for cashews (as measured on the demand curve) and the price they actually pay. Note that this area is a right triangle whose vertical arm is h=$4/pound and whose horizontal arm is b=4,000 pounds/day. Since the area of any triangle is equal to (1/2)bh, consumer surplus in this market is equal to (1/2)x(4,000 pounds/day)x($4/pound) = $8,000/day.

49 Consumer surplus A useful way of thinking about consumer surplus is to ask what is the highest price consumers would pay, in the aggregate, for the right to continue participating in this cashew market. The answer is $8,000 per day, since that is the amount by which their combined benefits exceed their combined costs. Suppose the government bans the operation of the cashew market. How much will the consumers, in aggregate, be willing to “bribe” or “lobby” the government to “re-open” the market? $8,000 per day in the previous example.

50 Example Consider the following two long-distance plans: AT&T: $20 per month plus 10 cents per minute MCI: $40 per month plus 5 cents per minute. Which of the following statements is NOT true? a.The AT&T plan is more likely to appeal to people who make relatively few long-distance calls. b.The MCI plan is more likely to appeal to people who make relatively many long-distance calls. c.A person who is involuntarily transferred from the MCI plan to the AT&T plan is likely to respond by making fewer long-distance calls. d.A rational person will choose the MCI plan only if it results in a smaller total phone bill than the AT&T plan. e.Three of the above statements are true. ✓ ✓ ✓

51 Example Which of the following statements is NOT true? d. A rational person will choose the MCI plan only if it results in a smaller total phone bill than the AT&T plan. e. Three of the above statements are true. If one of the statements is false, it must be d or e. If d is true, then e must be false (since d being true would mean that four of the above statements were true). Conversely, if d is false, e must be true (because a, b and c are true). So we must determine whether d is true.

52 Example Many believe that choice d is true. d. A rational person will choose the MCI plan only if it results in a smaller total phone bill than the AT&T plan. A common argument: “If a rational consumer wanted to place a given volume of calls each month, she would necessarily choose the billing plan that resulted in the smallest monthly bill.” Is this argument correct?

53 Example cents 5 cents Optimal number of calls given enrollment in the AT&T plan Optimal number of calls given enrollment in the MCI plan 50

54 Example When the demand is perfectly inelastic, a rational person only need to compare the costs of the two plans. Suppose a person has 1000 dollars to spend a month. If he enrolls is the MCI plan, he will have to pay *50 = 42.5 on phone services. If he enrolls in the AT&T plan, he will have to pay *50 = 25. Number of callsOther goods MCI50 ($42.5)$957.5= AT&T50 ($25)$975= Which do you prefer if you are the person with inelastic demand for calls? AT&T because we can consume the same number of calls as in MCI but with more other goods.

55 Example cents 5 cents Optimal number of calls given enrollment in the AT&T plan Optimal number of calls given enrollment in the MCI plan 500

56 Example When the demand is perfectly inelastic, a rational person only need to compare the costs of the two plans. Suppose a person has 1000 dollars to spend a month. If he enrolls is the MCI plan, he will have to pay *50 = 65 on phone services. If he enrolls in the AT&T plan, he will have to pay *500 = 70. Number of callsOther goods MCI500 ($65)$935= AT&T500 ($70)$930= Which do you prefer if you are the person with inelastic demand for calls? MCI because we can consume the same number of calls as in AT&T but with more other goods.

57 Example Many believe that choice d is true. d. A rational person will choose the MCI plan only if it results in a smaller total phone bill than the AT&T plan. A common argument: “If a rational consumer wanted to place a given volume of calls each month, she would necessarily choose the billing plan that resulted in the smallest monthly bill.” This argument is correct but yet its correctness does not imply that choice d is true.

58 Example A rational consumer does not necessarily wish to make a given volume of calls each month, irrespective of the rate at which those calls are billed. On the contrary, such a customer would represent the extreme case, someone whose demand for telephone services was completely inelastic with respect to price. More generally, consumers will elect to make more calls when they are on a plan with lower marginal charges. The goal of such consumers is not to minimize their monthly phone bills, but rather to choose the mix of phone services and other goods that maximizes their utility.

59 Example Might a rational consumer whose demand for telephone services is less than perfectly inelastic choose the MCI plan even though she would have a higher phone bill than under the AT&T plan? Consider, for example, a consumer whose demand for phone service is extremely elastic with respect to price. A reduction in the price of an elastically demanded good results in an increase in total expenditure on that good.

60 Example cents 5 cents Optimal number of calls given enrollment in the AT&T plan Optimal number of calls given enrollment in the MCI plan A rational person may compare his total utility from the calling services and the other goods, NOT the cost

61 Example A rational person may compare his total utility from the calling services and the other goods, NOT the cost. Suppose a person has 1000 dollars to spend a month. If he enrolls is the MCI plan, he will have to pay *500 = 65 on phone services. If he enrolls in the AT&T plan, he will have to pay *50 = 25. Number of callsOther goods MCI500 ($65)$935= AT&T50 ($25)$975= Which do you prefer? There are persons who may prefer the MCI package but the phone bill is higher when MCI is chosen.

62 Because the MCI plan has a lower marginal charge than the AT&T plan, someone with highly elastic demand for phone services might choose MCI knowing full well that the higher volume of calls she would make under it would result in a higher bill than she would have had under the AT&T plan. Thus d may not be correct when demand for calls is elastic.

63 End