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MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Overview of Market Allocation The economic problem Overview of markets, supply,

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Presentation on theme: "MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Overview of Market Allocation The economic problem Overview of markets, supply,"— Presentation transcript:

1 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Overview of Market Allocation The economic problem Overview of markets, supply, demand and market equilibrium Elasticity The demand side: benefits The Supply side: costs Market equilibrium Quest for profits and the invisible hand Market failures Alternatives and policies

2 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Announcements Exam next Tuesday Will post review questions tonight Tas will be announcing review sessions

3 MBMC Demand: The Benefit Side of The Market

4 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 4 Goals for this lecture Understand needs and wants Neoclassical and alternative approaches Introduce the concept of utility Understand the Equimarginal Principle of Optimization (rational spending rule for consumers) Relationship between individual demand curves and market demand for rival goods Understand consumer surplus

5 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 5 The Law of Demand People do less of what they want to do as the cost of doing it rises ‘Cost’ includes all individual costs (opportunity costs), but generally ignores costs to society Is this always true? E.g. speculation, housing bubble How do we know what people want to do? Preferences revealed in the market Africans ‘want’ to eat less than Americans

6 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 6 The Law of Demand The benefit of an activity to an individual equals the highest price (including opportunity costs) she’d be willing to pay to pursue it (i.e., the reservation price). ‘price’ needn’t be $$ Who gets a greater benefit from food, a malnourished African or an overfed American? As the cost to individuals of an activity rises and exceeds the reservation price (for the marginal unit), less of the activity will be pursued.

7 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 7 Examining the assumptions NYT Headlines High Prices Help Sell All-in-One Products In Tuition Game, Popularity Rises With Price

8 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 8 The Origins of Demand Needs vs. wants Do markets ensure needs are satisfied prior to wants? What determines “tastes” or “preferences”? No accounting for tastes. Has nothing to with moral values Are preferences exogenous or endogenous? Advertising- producers create demand Can needs and tastes be treated the same?

9 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 9 The Law of Demand The variety of human needs –Having, being, doing, interacting –How many of these derive from community? –Satisfiers and psuedosatisfiers Advertising and wants

10 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 10 Advertising and quality of life What’s a reasonable definition of quality of life? “The ability to satisfy your wants and needs” What does advertising do to your wants? What’s its impact on your ability to satisfy them?

11 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 11 Translating Wants into Demand How should we allocate our incomes among the various goods and services that are available? Demand = preferences (wants) weighted by income

12 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 12 Measuring wants: utility Utility Not directly measurable.  Is this true for essential, non-substitutable resource? Revealed preferences The satisfaction people derive from their consumption (having) activities  What about doing activities? Being activities?

13 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 13 Measuring wants: utility Assumption People allocate their resources to maximize their satisfaction or total utility Do you think this is true?

14 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 14 Sarah’s Total Utility from gas Consumption Gas quantity (gallons/day) Total utility (utils/day) 0 1 50 2 90 3120 4140 5150 6140 How much gas should Sarah consume if the gas is “free”?

15 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 15 Sarah’s Total Utility from gas Consumption gallons/day Utils/day 13456 0 2 150 140 120 90 50

16 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 16 Translating Wants Into Demand What do you think? Are the negative impacts of gasoline on society (e.g. oil spills, climate destabilization, air pollution, resource wars) relevant to how much she should order? Are they relevant to how much she does order? Is the time spent waiting in gas lines relevant?

17 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 17 Sarah’s Total Utility and Marginal Utility from gas Consumption gas quantity Total utilityMarginal utility (gallons/day) (utils/day)(utils/gallon) 0 1 50 2 90 3 120 4 140 5 150 6 140 50 40 30 20 10 -10 __ Do you think Sarah’s utility is the same as society’s utility?

18 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 18 Sarah’s marginal utility Diminishing Marginal Utility gallons/day Utils/gallon 13 4.5 0 1.50.5 4 3.5 2.5 2 50 40 30 20 10

19 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 19 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 to diminish as consumption increases beyond some point What happens if you assume this is not true?

20 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 20 Translating Wants into Demand Allocating A Fixed Income Between Two Goods Assume  Two goods: public or private transportation  Price of public trans. equals $2/trip  Price of gas equals $1/liter  Sarah’s budget = $400/yr  Currently Sarah is consuming 200 liters of gas and 100 trips on public transportation

21 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 21 Translating Wants into Demand Question Is Sarah maximizing her total utility?

22 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 22 Marginal Utility Curves for Two types of transportation (I) liters/yr Marginal utility of gas (utils/ liter) Marginal utility of public transportation (utils/trip) trips/yr 12 200 16 100

23 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 23 Translating Wants into Demand Marginal utility gas/liter $12/1 = 12 utils/$ Marginal utility pub trans/trip 16/2 = 8 utils/$

24 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 24 Translating Wants into Demand If Sarah spends $2 less on pub trans, utils will decline by 16. If Sarah spends $2 more on gas, utils will increase by 24 So… Sarah gets more utility if she buys more gas How much gas should Sarah buy?

25 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 25 Consuming more gas leads to lower marginal utility liters/yr Marginal utility of gas (utils/ liter) 10 250

26 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 26 Consuming less public transportation leads to higher marginal utility Marginal utility of public trans. (utils/ trip) trips/yr 20 75

27 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 27 The equimarginal principle of optimization AKA the rational spending rule Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

28 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 28 The equimarginal principle of optimization This applies to all goods Is it an optimal outcome for society? How could we improve the outcome? What will make people consume less of a good? What would happen if we subsidized public transportation?

29 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 29 Translating Wants into Demand Income and Substitution Effects Revisited How should Sarah respond to a reduction in the price of public transportation?

30 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 30 Translating Wants into Demand Assume Budget = $400 P PT = $2 & P G = $1 Q PT = 75 & Q G = 250

31 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 31 Translating Wants into Demand Assume Price of public trans.falls to $1 So what should Sarah do?

32 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 32 Individual and Market Demand Curves for Canned Tuna Price ($/can) Smith’s quantity 12 6 14 16 10 8 6 4 2 0 (cans/week) 248 Price ($/can) Jones’s quantity 12 6 14 16 10 8 6 4 2 0 (cans/week) 248 Smith Jones + Horizontal Addition

33 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 33 Individual and Market Demand Curves for Canned Tuna Price ($/can) Total quantity 12 6 14 16 10 8 6 4 2 0 (cans/week) 2481210 = Market Demand curve

34 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Individual Demand for food Value: low and stable Trade-offs: relatively unimportant benefits Value: shift from marginal to total value (e.g. diamond-water paradox) Trade-offs: Life sustaining benefits Value: Increasing rapidly with decreasing quantity. Trade-offs: Resilience, increasingly important benefits physiological threshold: e.g. starvation food security, household security

35 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 35 Individual and Market Demand Curves for Food

36 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Market Demand for food Trade-offs: poor go hungry Poor starve, middle class goes hungry food security, household security price

37 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 37 The Individual and Market Demand Curves When All Buyers Have Identical Demand Curves Price ($/can) Total quantity 6 6 5 4 3 2 1 0 (cans/month) 2481210 D Total quantity 6 6 5 4 3 2 1 0 (1000s of cans/month) 2481210 D Price ($/can) Each of 1,000 consumers have the same demand Market Demand = P x number of consumers (1,000)

38 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 38 Demand and Consumer Surplus Consumer Surplus The difference between a buyer’s reservation price for a product and the price actually paid

39 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 39 Demand and Consumer Surplus Question How much do buyers benefit from their participation in the market for milk?

40 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 40 Supply and Demand in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) 1.50 1.00 1.50 2.00 2.50 3.00 234567891011120 S D

41 MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5: Demand: The Benefit Side of the Market Slide 41 Consumer Surplus in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) 1.50 1.00 1.50 2.00 2.50 3.00 234567891011120 S D Consumer surplus h = $1/gallon b = 4,000 Consumer surplus = (1/2)(4,000)(1) = $2,000/day Do we know what the demand curve looks like? Is this level of precision appropriate?


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