1. 1 Chapter 5: Demand Question: Given that a person can consume a combination of food and clothes at any point on the budget line, which point would satisfy the person the most? A or B or any other point? Food Clothes A B Budget line

2. 2 Demand People allocate their limited income among different goods and services to maximize their satisfaction. –Utility: the satisfaction people derive from consumption Subjective Not comparable between people Individuals’ goal is to maximize their utility –Revisit the cost-benefit principle People would consume one more unit of food only if the marginal utility of doing so is at least as large as its cost, which is the utility lost from the reduction in the consumption of clothes.

3. 3 Utility – An Example Sarah's Utility from Ice Cream Cones / Hour0123456 Total Utility05090120140150140 Cones/hour Utils/hour 134562 150 140 120 90 50

4. 4 Utility – An Example (Cont.) Sarah's Marginal Utility from Ice Cream Cones / Hour0123456 Total Utility05090120140150140 Marginal Utility5040302010-10  Marginal utility: the additional utility from consuming one more Marginal utility = Change in utility Change in consumption

5. 5 Diminishing Marginal Utility As consumption increases beyond some point, the marginal utility gained from consuming additional unit of a good tends to decrease.

6. 6 Marginal Utility ε = P Q 1 slope x Given a fixed income, how would a person choose between two goods in order to maximize his/her utility from consumption? -Compare the marginal utility gained from choosing one good with the marginal utility lost from giving up another good; -Law of Diminishing Marginal Utility applies –As you buy more of a single good, its marginal utility decreases –When you buy less of that good, its marginal utility increases

7. 7 Utility Maximization – An Example ε = P Q 1 slope x Pints/yr Vanilla Ice Cream 12 200 MU (utils/ pint) Chocolate Ice Cream Pints/yr 16 100 MU (utils/ pint) $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 Sarah's Ice Cream

8. 8 Utility Maximization – An Example Susan can increase her utility by consuming less Chocolate and more Vanilla –Reduce one pint of chocolate saves her $2, with which Susan can buy two more pints of vanilla ($1 per pint); –Marginal utility lost from giving up one pint of chocolate = 16 utils; –Marginal utility gained from two more pints of vanilla = 2x12=24 utils; –Gain > Loss, Susan should buy more vanilla and less chocolate; –So, under what conditions would Susan maximizes her total utility? In other words, what is the optimal combination of chocolate and vanilla that gratifies Susan the most?

9. 9 Utility Maximization – An Example Pints/yr Vanilla Ice Cream 200 MU (utils/ pint) 300 8 12 Chocolate Ice Cream Pints/yr 16 100 MU (utils/ pint) 50 24  Increase vanilla by 100  Reduce chocolate by 50  Marginal utility of vanilla is 8  Marginal utility of chocolate is 24

10. 10 Utility Maximization – An Example MU (utils/ pint) Pints/yr Vanilla Ice Cream 250 10 MU (utils/ pint) Chocolate Ice Cream Pints/yr 20 75 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

11. 11 Utility Maximization – An Example Scenario 1PriceQuantityMarginal UtilityMU / $ Vanilla$120012 Chocolate$2100168 Scenario 2PriceQuantityMarginal UtilityMU / $ Vanilla$130088 Chocolate$2502412 Scenario 3PriceQuantityMarginal UtilityMU / $ Vanilla$125010 Chocolate$2752010

12. 12 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 The Rational Spending Rule Spending should be allocated across goods so that the marginal utility per dollar is the same for each good MU 1 / P 1 = MU 2 / P 2

13. 13 Rational Spending Rule Substitution effect –Suppose, one starts with MU 1 /P 1 =MU 2 / P 2 ; –When P 1 increases, MU 1 /P 1 <MU 2 / P 2 ; –According to the rational spending rule, one should increase spending on good 2 and reduce spending on good 1 until MU 1 /P 1 =MU 2 / P 2 again; –So explained is the substitution effect.

14. 14 Rational Spending Rule  Is Eric following the Rational Spending Rule?  What matters is the marginal utility in the rational spending rule. Eric's Apples ApplesOranges Total Expenditures$100$50 Price$2$1 Total Utility1,000400 Quantity50

15. 15 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

16. 16 Consumer Surplus Consumer's surplus is the difference between the buyer's reservation price and the market price 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 D Units/day 1 2 3 4 5 6 7 8 9 10 11 12 24681012 Vanilla Ice Cream Marginal utility (utils/ pint)

17. 17 Consumer Surplus 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 D 1 2 3 4 5 6 7 8 9 10 11 12 24681012 Vanilla Ice Cream Units/day Marginal utility (utils/ pint)

18. 18 Consumer Surplus: An Example Price is $2 and quantity is 4,000 gallons per day Consumer surplus is the area of the triangle formed by –Demand curve –Vertical axis –Horizontal intercept of demand curve –Remember: area of a right triangle is ½ width times height The area is ½ ($1)(4,000 gal) = $2,000 Quantity (000s of gal/day) Price ($/gallon) 1 1.00 2.00 3.00 23456 S D Consumer Surplus