1. Stephen Chiu University of Hong Kong
Demand: The Benefit
Side of the Market
Stephen Chiu University of Hong Kong

2. The Law of Demand
People do less of what they want to do as the cost of doing it rises.
Thus, we eat less of ice cream when it is more expensive.
Law of Demand

3. The Law of Demand
The benefit of an activity to me equals the highest price I’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

4. Translating Wants into Demand
How should we allocate our income among the various goods and services that are available?

5. 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.

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

7. Example 5.1. John’s Total Utility from Sushi Consumption
Pieces /hr
Total U /hr 1 50 2 90 3
120 4
140 5
150 6
150
140
120 90 50
Utils/hour
How many pieces of sushi should John consume if the sushi is “free”? 1 2 3 4 5 6
Pieces of sushi /hour

8. Example 5.2. John’s Marginal Utility from Sushi Consumption50 40 30 20 10
John’s
marginal
utility
Pieces
Total U
Marginal U -- 1 50 2 90 40 3
120 30 4
140 20 5
150 10 6
-10
Utils/cone
The marginal utility from consuming a good is the additional utility that results from consuming an additional unit of the good. 1 2 3 4
0.5
1.5
2.5
3.5
4.5
pieces/hour

9. 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.

10. The optimal combination of goods
The optimal combination of goods is the 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.

11. 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.
MU1/P1 = MU2/P2
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.

12. Example 5.3. Is Susan maximizing her utility from consuming cashews and pistachios?
Cashew nuts sell for $8 per pound and pistachios sell for $4 per pound. Susan 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?
pistachio
Cashew

13. Example 5.3. Is Susan 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, Susan is spending her entire $800 annual budget for nuts.

14. Example 5.3. Is Susan 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.

15. Example 5.3. Is Susan 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 Susan cannot possibly be maximizing her total utility.

16. Example 5.4. Is Susan maximizing her utility from consuming cashews and pistachios (III)?
Susan’s total nut budget and the prices of the two flavors are again as in Examples 5.3.
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?

17. Example 5.7. Is Susan maximizing her utility from consuming cashews and pistachios (III)?
This time Susan 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.

18. The Rational Spending Rule for two goods, X and Y:
MUX/PX = MUY/PY.
Suppose MUX/PX > MUY/PY.
Then you can increase total utility by spending a dollar less on Y and a dollar more on X.
Suppose MUX/PX = 3 > 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.

19. The Rational Spending Rule for N goods:
MU1/P1 = MU2/P2 = ... = MUN/PN .

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

21. Example: When the price of energy rises …
We buy smaller cars …

22. Example: When the price of energy rises …
Sell our cars … take public transportation …

23. Adding Individual Demand Curves To Get Market Demand Curves (Horizontal Addition)
Suppose that there are 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.

24. Adding Individual Demand Curves To Get Market Demand Curves (Horizontal Addition)

25. 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.

26. Example 5.12. 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.

27. Example 5.5. 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?

28. Example 5.6. How much do buyers benefit from their participation in this market for cashews?

29. Example 5.6. 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.

30. End