Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-1 Chapter 5 Demand: the benefit side of the market

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-2 The law of demand The quantity demanded of a good or service declines as its price rises and increases as its price falls, ceteris paribus.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-3 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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-4 The law of demand The origins of demand –What determines ‘tastes’ or ‘preferences’?  Biology  Culture  Peer influences

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-5 The law of demand Thinking as an economist –Needs vs. wants –Why have many Australian cities made watering restrictions permanent?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-6 Translating wants into demand How should we allocate our incomes among the various goods and services that are available?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-7 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 maximise their satisfaction or total utility.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-8 Translating wants into demand How much of a free good should we use?  The cost of waiting is worth it if people get free goods.  How many free sausages will an individual want to consume?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-9 Alice’s total utility from sausage consumption Sausage quantity (sausages/hour) Total utility (utils/hour) How many sausages should Alice consume if the sausage is ‘free’?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-10 Alice’s total utility from sausage consumption Sausages/hour Utils/hour

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-11 Translating wants into demand What should Alice 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 sausages to order?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-12 Alice’s total utility and marginal utility from sausage consumption Sausage quantity Total utilityMarginal utility (sausages/hour) (utils/hour)(utils/sausage) __

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-13 Alice’s marginal utility Diminishing marginal utility Sausages/hour Utils/sausage

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-14 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 in a given period of time to diminish as consumption increases beyond some point.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-15 Translating wants into demand How should we allocate a fixed income between two goods? –Assume  Two goods: beef and venison sausages  Price of venison sausages equals $2/kg  Price of beef sausages equals $1/kg  Alice’s budget = $400/yr  Currently Alice is buying 200 kg of beef and 100 kg of venison sausages each year

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-16 Translating wants into demand Question –Is Alice maximising her total utility?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-17 Marginal utility curves for two varieties of sausages (I) kg/year Marginal utility of beef sausages (utils/kg) Marginal utility of venison sausages (utils/kg) kg/year

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-18 Translating wants into demand Marginal utility beef/kg –12/1 = 12 utils/$ Marginal utility venison/kg –16/2 = 8 utils/$

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-19 Translating wants into demand If Alice spends $2 less on venison, utils will decline by 16. If Alice spends $2 more on beef, utils will increase by 24. So … –Alice should buy more beef.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-20 Marginal utility curves for two varieties of sausages (II) kg/year Marginal utility of beef sausages (utils/kg) Alice increases beef spending by $100, and MU V /P V = 8/$1 = 8

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-21 Marginal utility curves for two varieties of sausage (II) Marginal utility of venison sausages (utils/kg) kg/year Alice decreases venison spending by $100, and MU C /P C = 24/$2 = 12 > MU V /p V = 8

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-22 Marginal utility curves for two varieties of sausage (III) kg/year Marginal utility of beef sausages (utils/kg)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-23 Marginal utility curves for two varieties of sausage (III) Marginal utility of venison sausages (utils/kg) kg/year 20 75

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-24 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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-25 Translating wants into demand The rational spending rule –How is the rational spending rule related to the cost-benefit principle?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-26 Translating wants into demand Income and substitution effects revisited –How should Alice respond to a reduction in the price of venison sausages?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-27 Marginal utility curves for two varieties of sausage (III) kg/year Marginal utility of beef sausages (utils/kg) Marginal utility of venison sausages (utils/kg) kg/year

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-28 Translating wants into demand Assume –Budget = $400 –P C = $2 & P V = $1 –Q C = 75 & Q V = 250

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-29 Translating wants into demand Assume –Price of venison falls to $1.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-30 Applying the rational spending rule Substitution at work When the price of a good or service goes up, rational consumers generally turn to less expensive substitutes. Thinking as an Economist –Why is the average size of a wealthy resident’s house in Seattle twice that of one in Manhattan?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-31 Applying the rational spending rule Thinking as an economist –Why do new car sales continue to boom, despite rising real petrol prices?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-32 Applying the rational spending rule Income differences at work Thinking as an economist –How does strong growth in incomes help explain the steadily increasing proportion of Australian domestic expenditure spent on imported goods?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-33 Applying the rational spending rule The importance of income differences –Why are waiting lines longer in poorer suburbs?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-34 Individual and market demand curves for canned tuna Price ($/can) Smith’s quantity (cans/week) 248 Price ($/can) Jones’ quantity (cans/week) 24 Smith Jones + Horizontal addition

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-35 Individual and market demand curves for canned tuna Price ($/can) Total quantity (cans/week) = Market demand curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-36 The individual and market demand curves when all buyers have identical demand curves Price ($/can) Total quantity (cans/month) D Total quantity (1000s of cans/month) D Price ($/can) Each of 1000 consumers have the same demand Market demand = P x number of consumers (1000)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-37 Demand and consumer surplus Consumer surplus –The difference between a buyer’s reservation price for a good and the price actually paid.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-38 Demand Calculating consumer surplus A market with a ‘digital’ demand curve Units/day Price ($/unit)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-39 Consumer surplus Units/day (Price ($/utils) Demand 0 Consumer surplus = $15/day

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-40 Demand and consumer surplus Question –How much will residents of the mountain village benefit from being able to participate in the market for fish if the road linking them to the coast is built?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-41 Consumer surplus in the market for fish Quantity (1000s of kg/day) Price ($/kg) S D

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5-42 Consumer surplus in the market for fish Quantity (1000s of kg/day) Price ($/kg) S D Consumer surplus h = $1/kg b = 4000 kg/day Consumer surplus = (1/2)(4000 kg/day)($1/kg) = $2000/day