1. Demand Chapter 5 ©McGraw-Hill Education. All rights reserved.

2. Learning Objectives
Relate the law of demand to the Cost-Benefit Principle
Discuss how individual wants are translated into demand
Explain the reasoning behind the rational spending rule and apply it to consumer decision making to show how the rule is related to substitution and income effects
Discuss the relationship between the individual demand curve and the market demand curve
Define and calculate consumer surplus
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3. Free Ice Cream – Or Is It?
The cost of a good extends beyond its monetary cost
Waiting in line
Purchasing a permit
Participating in a lottery
"Free" ice cream attracts so many consumers that the time spent waiting in line acts as the price of the good
Demand curves relate the quantity demanded to ALL costs, not just monetary costs
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4. Law of Demand
Law of Demand People do less of what they want to do as the cost of doing it rises
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5. Law of Demand Cost-Benefit Principle at work
Do something if the marginal benefits are at least as great as the marginal costs
An increase in the market price approaches our reservation price
If market price exceeds the reservation price, buy no more
Costs include ALL costs – money, time, reputation
Consider implicit and explicit costs
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6. Origins of Demand Reservation price
Individual tastes and preferences differ
Biological needs ■ Cultural influences
Peer behavior ■ Individual differences
Perceived quality ■ Expected benefits
Tastes may change over time
Macaroni and cheese
Spinach
New goods get incorporated into priorities
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7. Needs versus Wants Some goods are required for subsistence
These are needs
Beyond subsistence, behavior is driven by wants
Kidneys or hamburger
Oatmeal or toaster pastries
Wants depend on price
Water in California
Regulations or price mechanism
Regulations are cumbersome and expensive
Price changes are fast and effective
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8. California Water Shortages
Problem: California has a large population and relatively low annual rainfall, so some argue that water shortages are inevitable
Analysis
New Mexico has less rainfall per person and fewer shortages
California's water price is low
Low price discourages careful use
Rice is grown because water is cheap
Water-intensive home landscaping
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9. Wants and Demand Unlimited wants Limited resources Prioritize wants
More things, better quality things
Services, including entertainment and travel
Limited resources
Money, income, and wealth
Time and energy
Prioritize wants
Allocate resources accordingly
Demand those things for which you are willing and able to pay
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10. Wants and Utility
Utility: the satisfaction people derive from consumption
Well-being, happiness
Measured indirectly
Subjective
Observable
Cannot be compared between people
Individual goal is to maximize utility
Allocate resources accordingly
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11. Sarah's Utility from Ice Cream
Cones / Hour 1 2 3 4 5 6
Total Utility 50 90
120
140
150
Cones/hour
Utils/hour 1 3 4 5 6 2
150
140
120 90 50
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12. Sarah's Marginal Utility from Ice Cream
Marginal utility: the additional utility from consuming one more
Cones / Hour 1 2 3 4 5 6
Total Utility 50 90
120
140
150
Marginal Utility 50 40 30 20 10
-10
Marginal utility =
Change in utility
Change in consumption
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13. The Consumer’s Preferences
Assume that the consumer intends to buy two goods: X and Y
More of X or Y is better for the consumer
The consumer’s commodity basket: (Xi, Yi)
She is capable of comparing any commodity baskets pairwise
Strictly preferred basket:
Weakly preferred basket:
Indifferent baskets:

14. Three Axioms About Consumer’s Preferences
Completeness
Each consumer is capable of comparing all commodity baskets to any other baskets
Reflexivity (Ordinability)
If then cannot occur
Transitivity
If and then

15. The Indifference CurveY X
(X2, Y2)
(X1, Y1)
(X1, Y1) ~ (X2, Y2)
(X1, Y1) ~ (X2, Y2) > (X4, Y4)
(X1, Y1) ~ (X2, Y2) < (X3, Y3)
(X3, Y3)
(X4, Y4)

16. Utility Function The rules
Assigning numbers to each utility level (to each indifference curve) – based on the three axioms – results in the utility function
The rules
Any positive transformation of the original utility
function will be as appropriate as the original
one

17. Utility Function of Perfect Substitution
If you are willing to substitute 3 cups of tee for 2 cups of coffee, then the utility function can be described as
In general terms:

18. Utility Function of Perfect Substitution
The slope of the indifference curves will be constant at each point of consumption
Slope = 2/3
At any utility level: C T
(C, T) 2 3 5
6.5 8 12

19. Utility Function of Perfect Complementarity
Two goods are jointly consumed
You drink a cup of coffee with two a quarter pint of milk
In general: C M
(C, M) 1
1/4 2
1/2 8

20. Utility Function of Imperfect Substitution
You are willing to substitute the Guns N’ Roses concert for going to a movie, but your ratio of substitution is changing depending on the number of concerts you have attended and/or the number of movies you already watched this year.
In general:
It is called the Cobb-Douglas utility function

21. Utility Function of Imperfect Substitution
The Cobb-Douglas utility function can be represented as follows: C M
(C, M) 8

22. The Map of Indifference Curves
An indifference curve represents a certain utility level
“The more is the better”
Consumers will choose their optimum level of consumption partly based on their preferences (utility level) that is represented by the indifference curves

23. Marginal Utility Function
If a consumer opts for a commodity basket
, where is the
quantity chosen from commodity k, the
marginal utility function is the partial derivative
of How much will the
consumer’s utility change should she/he
consume an additional unit of commodity k.

24. Diminishing Marginal Utility
Law of Diminishing Marginal Utility Tendency for additional utility gained from consuming an additional unit of a good to decrease as consumption increases beyond some point
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25. Diminishing Marginal Utility
Marginal utility can increase at low levels of consumption
First unit stimulates your desire for more
First MP-3 player in a 5-person household
First potato chip
Eventually, marginal utility declines
Continue consuming
Apply Cost-Benefit Principle
Consume an additional unit as long as the marginal utility (benefit) is greater than the marginal cost
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26. Spending on Two Goods Assume a fixed budget
Decide how much of each good to buy
Law of Diminishing Marginal Returns applies
As you buy more of a single good, its marginal utility decreases
When you buy less of that good, its marginal utility increases
Marginal utility increases as quantity decreases
Marginal Utility
Marginal utility decreases as quantity increases
Marginal Utility
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27. Budget Allocation
Maximize utility when the marginal utility per dollar spent is the same for all goods
No Money Left On the Table Principle
Current spending has marginal utility of a dollar spent on one good higher than the marginal utility of a dollar spent on the other good
Take a dollar away from the good with low marginal utility and spend it on the good with high marginal utility
Marginal utilities per dollar begin to equalize
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28. The Budget Constraint
The consumer faces market prices of those commodities that she/he intends to buy:
, while her/his nominal
(monetary) income is m.
She/he cannot spend more than the income. That is her/his budget constraint:
is the income share spent on item k.

29. Sarah's Ice Cream $400 budget
Chocolate is $2 per pint
Vanilla is $1 per pint
Buy 200 pints of vanilla and 100 pints of chocolate
Marginal utility is 12 for vanilla, 16 for chocolate
Chocolate Ice Cream
Pints/yr 16
100
MU (utils/ pint)
Vanilla Ice Cream
MU (utils/ pint) 12
200
Pints/yr
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30. Sarah's Next Step Increase vanilla by 100
Reduce chocolate by 50
Marginal utility of vanilla is 8
Marginal utility of chocolate is 24
Chocolate Ice Cream
Pints/yr 16
100
MU (utils/ pint) 50 24
Vanilla Ice Cream
200
300 8 12
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31. Sarah's Equilibrium Optimal combination: highest total utility
250 pints vanilla; 75 pints chocolate
Marginal utility / price is the same for all goods
Marginal utility of vanilla 10, chocolate 20
MU (utils/ pint)
Pints/yr
Vanilla Ice Cream
250 10
MU (utils/ pint)
Chocolate Ice Cream
Pints/yr 20 75
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32. Sarah's Choices Scenario 2 Price Quantity Marginal Utility MU / $
Vanilla $1
200 12
Chocolate $2
100 16 8
 Scenario 2
Price
Quantity
Marginal Utility
MU / $
Vanilla $1
300 8
Chocolate $2 50 24 12
 Scenario 3
Price
Quantity
Marginal Utility
MU / $
Vanilla $1
250 10
Chocolate $2 75 20
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33. Rational Spending Rule
The Rational Spending Rule
Spending should be allocated across goods so that the marginal utility per dollar is the same for each good
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34. Rational Spending Rule
Rational Spending Rule can be written algebraically
Notation
MUC is the marginal utility from chocolate
MUV is the marginal utility from vanilla
PC is the price of chocolate
PV is the price of vanilla
Rational Spending Rule
MUC / PC = MUV / PV
The marginal utility per dollar spent on chocolate equals the marginal utility per dollar spent on vanilla
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35. The Consumer’s Optimal Choice
The consumer wants to maximize her/his utility taking into account her/his budget constraint:
Conditional optimization

36. The Consumer’s Optimal ChoiceY X
(X*, Y*) U1 U2 U3

37. Substitution Effect (1)
When the price of a good goes up, substitutes for that good are relatively more attractive
At the higher price less is demanded because some buyers switch to the substitute good
If the price of vanilla ice cream goes up, some buyers will buy less vanilla and more chocolate
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38. Substitution Effect (2)
Assume that px increased. How much would a consumer’s demand for commodity X change if her real income hasn’t changed. Y X
(X*, Y*) U1 U2 U3 SE
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39. Income Effect (1) Changes in price affect the buyers' purchasing power
Acts like a change in income
Suppose vanilla ice cream goes from $1 per pint to $2
If Sarah spends all her income on vanilla, the amount she can buy goes down by half
At the original prices, she could buy 100 pints of vanilla and 150 pints of chocolate
At new price for vanilla, she buys 100 vanilla and only 100 chocolate
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40. Income Effect (2)
How large is the change in consumer’s demand for commodity X if only her real income decreased? Y X
(X*, Y*) U1 U2 U3 IE
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41. Total Effect of a Price Change on Demand
The impact of a nominal income change on demand
Normal goods:
Inferior goods:
The impact of a price change on demand
Common goods:
Giffen goods:
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42. Decomposing the Effect of a Price Change
TE decomposed: SE IE = TE
Normal and
Common goods: ( – ) ( – ) = ( – )
Common and
Inferior goods: ( – ) ( + ) = ( – )
Inferior and
Giffen goods: ( – ) ( + ) = ( + )

43. The Law of Demand
If a commodity’s demand is increasing whenever the consumer’s income is also increasing then the same commodity’s demand will decrease if its price is increasing.
This change will always occur with a normal good.
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44. Rational Spending and Price Changes
Suppose price of vanilla increases from $1 to $2
At the original equilibrium
MUC / PC = MUV / PV
With the increase in PV, MUV / PV < MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up
To get to a new optimal spending point,
Buy more chocolate
Buy less vanilla
Stop when the marginal utility per dollar is the same
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45. Chocolate Ice Cream Price Goes Down
Originally: $400 budget, $1 per pint for vanilla, and $2 per pint for chocolate
What if chocolate is now $1 per pint?
With the increase in PV,
MUV / PV > MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up
To get to a new optimal spending point,
Buy more chocolate
Buy less vanilla
Stop when marginal utility per dollar is the same
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46. Is Eric following the Rational Spending Rule?
Eric's Apples
Apples
Oranges
Total Expenditures
$100
$50
Price $2 $1
Total Utility
1,000
400
Quantity 50
Is Eric following the Rational Spending Rule?
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47. Applying the Rational Spending Rule: Substitution at Work
Substitution has powerful effects on our choices
New car or used one
Car pool or bus
French restaurant, Chinese restaurant, cook at home
Soccer game or TV, or read a book
Go to movies or join Netflix, or get cable TV
Turn on the heat or put on a hoodie
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48. Example: Smaller Homes in Manhattan
Observation: Wealthy people in Seattle have larger homes than wealthy people in Manhattan
Seattle houses twice the size of Manhattan houses
Analysis
Housing prices are higher in Manhattan
Land is more expensive
Construction costs are higher
New Yorkers buy less housing and spend more on other goods such as vacation homes, travel, restaurant meals, and theater tickets
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49. Nominal and Real Prices
Nominal price: the absolute price of a good in terms of dollars
The price you see on a good in a store
Real price: the nominal price of a good relative to the average dollar price of all other goods
Real prices are adjusted for inflation
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50. Example: How Many Cylinders in Your Car?
Observation: People bought 4-cylinder cars in the 1970s, returning to 6- and 8-cylinder cars in the 1990s
Analysis
1973 gas price was higher in real terms than in 1999
$1.40 in 1999 bought more other goods than $0.38 bought in 1973
With lower real gas prices, people bought bigger cars
SUV market boomed in the 1990s
High gas prices in 2004 reversed the trend again
1973
1974
1979
1999
Gas Price
$0.38
$0.90
$1.19
$1.40
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51. Income Differences Matter
Income is one of the determinants of demand
"Free goods" have more takers in lower income neighborhoods than in higher income areas
The wait to get the free good is the price
Waiting times in lower income areas will be longer
Lower opportunity cost of the residents' time
Stores in higher income areas have lower waiting times to pay for purchases
The higher value of time causes these people to be willing to pay for more store staff
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52. Individual and Market Demand Curves
The market demand is the horizontal sum of individual demand curves
At each possible price, add up the number of units demanded by individuals to get the market demand
Smith
Jones
Market
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53. Identical Individual Demand Curves
In the special case where all buyers demand exactly the same quantity at each price
Multiply the individual quantity demanded by the number of buyers to get the market demand
Individual
Market
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54. Consumer Surplus
Consumer surplus is the difference between the buyer's reservation price and the market price
With multiple buyers
Find the consumer surplus for each buyer
Add up the individual surplus for each buyer
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55. Consumer Surplus on a Graph
When a product is sold in whole units, the demand curve is a stair-step function
Many goods are indivisible: movie tickets and TVs
If the market supplied only one unit, the maximum price would be $11
For the second unit, the price is $10, and so on
The last buyer gets no consumer surplus
Vanilla Ice Cream 12 11 10 9 8 7
Marginal utility (utils/ pint) 6 5 4 3 2 D 1 2 4 6 8 10 12
Units/day
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56. Consumer Surplus on a Graph
Market price is $6 for all sales
Total consumer surplus
The first sale generates $5 of consumer surplus
Reservation price of $11 minus the price of $6
Selling the second unit has $4 of consumer surplus, and so on
Total consumer surplus is the area under the demand curve and above market price
Vanilla Ice Cream 12 11 10 9 8 7
Marginal utility (utils/ pint) 6 5 4 3 2 D 1 2 4 6 8 10 12
Units/day
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57. Consumer Surplus for Milk
Consider the market demand and supply of milk
The equilibrium price is $2 per gallon
The equilibrium quantity is 4,000 gallons per day
Last customer pays his reservation price and gets no consumer surplus
Quantity (000s of gal/day)
Price ($/gallon) 1
1.00
2.00
3.00 2 3 4 5 6 S D
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58. Consumer Surplus for Milk
Price is $2 and quantity is 4,000 gallons per day
Consumer surplus is the area of the triangle between:
Horizontal intercept of demand
Market price
Market quantity
Remember: area of a right triangle is ½ base times height
The area is ½ (4,000 gal)($1) = $2,000
Quantity (000s of gal/day)
Price ($/gallon) 1
1.00
2.00
3.00 2 3 4 5 6 S D
Consumer Surplus
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59. Calculating Consumer Surplus
The slope of the (inverse) demand curve is: 1/4
Consequently, the demand equation will be:
CS is the area below the Inverse demand curve between Q = 0 and Q = 4.
Quantity (000s of gal/day)
Price ($/gallon) 1 2 3 4 5 6 S D
Consumer Surplus
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60. Cost – Benefit Principle Rational Spending Rule
Demand
Individual Wants
Consumer Surplus
Cost – Benefit Principle
Rational Spending Rule
Market Demand
Substitution Effects
Income Effects
Law of Demand
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