11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 5: Ch. 5: Demand - The Benefit Side of The Market

22

QuestionsQuestions If free ice cream is available between 2 If free ice cream is available between 2

PM and 4 PM, do every one who is PM and 4 PM, do every one who is attracted to the site get it?attracted to the site get it?What is the MC in monetary terms?What is the MC in monetary terms?What is the MC in opportunity cost terms?What is the MC in opportunity cost terms?How is ice cream allocated among How is ice cream allocated among

consumers?consumers?

33

Law of DemandLaw of DemandThe costly one views an activity, the less The costly one views an activity, the less

likely one will do it.likely one will do it.The lower the cost of a good/service/activity, The lower the cost of a good/service/activity,

the more of it will be “consumed.”the more of it will be “consumed.”

44

Law of DemandLaw of DemandThe benefit of an activity equals the highest The benefit of an activity equals the highest

price we’d be willing to pay to pursue it (i.e., price we’d be willing to pay to pursue it (i.e., the reservation price).the reservation price).

As the cost of an activity rises and exceeds As the cost of an activity rises and exceeds the reservation price, less of the activity will the reservation price, less of the activity will be pursued.be pursued.

55

Needs vs WantsNeeds vs Wants ““Californians don’t have as much water as Californians don’t have as much water as

they need!”they need!” ““Californians don’t have as much water as Californians don’t have as much water as

they want at the ongoing price of water!”they want at the ongoing price of water!”

66

Measuring Wants: The Measuring Wants: The Concept of UtilityConcept of Utility

UtilityUtilityThe satisfaction people derive from their The satisfaction people derive from their

consumption activitiesconsumption activitiesAssumptionAssumption

People allocate their income to maximize their People allocate their income to maximize their satisfaction or total utilitysatisfaction or total utility

77

Sarah’s Total Utility Sarah’s Total Utility from Ice Cream Consumptionfrom Ice Cream ConsumptionCone quantity (cones/hour) Total utility (utils/hour)

0 01 502 903 1204 1405 1506 140

How much ice cream should Sarah consume if the ice cream is “free”?

How many cones should she order once she is at the counter?

Is the time spent in the line relevant to how many cones to order?

88

Sarah’s Total Utility Sarah’s Total Utility from Ice Cream Consumptionfrom Ice Cream Consumption

Cones/hour

Util

s/ho

ur

1 3 4 5 60 2

150140

120

90

50

99

Sarah’s Marginal Utility from Sarah’s Marginal Utility from Ice Cream ConsumptionIce Cream Consumption

Cone quantity Total utility Marginal utility(cones/hour) (utils/hour) (utils/cone)

0 01 502 903 1204 1405 1506 140

50 40 30 20 10-10

1010

Diminishing Marginal UtilityDiminishing Marginal Utility50

40

30

20

10

Sarah’smarginalutility

0

0.5 1 1.5 2 2.5 3.5 43 4.5

1111

The Law of Diminishing The Law of Diminishing Marginal UtilityMarginal Utility

The tendency for the additional utility gained The tendency for the additional utility gained from consuming an additional unit of a good from consuming an additional unit of a good to diminish as consumption increases beyond to diminish as consumption increases beyond some pointsome point

1212

Allocating A Fixed Income Allocating A Fixed Income Between Two GoodsBetween Two Goods

Two goods: Chocolate and vanilla ice Two goods: Chocolate and vanilla ice creamcream

Price of chocolate equals $2/pintPrice of chocolate equals $2/pintPrice of vanilla equals $1/pintPrice of vanilla equals $1/pintSarah’s budget = $400/yrSarah’s budget = $400/yrCurrently Sarah is consuming 200 pints of Currently Sarah is consuming 200 pints of

vanilla and 100 pints of chocolatevanilla and 100 pints of chocolate

1313

Marginal Utility Curves for Marginal Utility Curves for Two Flavors of Ice CreamTwo Flavors of Ice Cream

Mar

gina

l util

ity o

f van

illa

ice

crea

m(u

tils/

pin

t)

Mar

gina

l util

ity o

f cho

cola

te ic

e cr

eam

(util

s/ p

int)

12

200

16

100Pints/yr Pints/yr

1414

Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?Total Utility?

Marginal utility vanilla/P: $12/1 = 12 utils/$Marginal utility chocolate/P: 16/2 = 8 utils/$

If Sarah spends $2 less on chocolate, utils will decline by 16.If Sarah spends $2 more on vanilla, utils will increase by 24.

So…Sarah should buy more vanilla and less chocolate.

1515

Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?Total Utility?

But how much more vanilla and how much But how much more vanilla and how much less chocolate?less chocolate?

Until MUUntil MUvv/P/Pv v = MU= MUcc/P/Pcc

If MUIf MUvv/P/Pv v > MU> MUcc/P/Pc c then buy more vanilla then buy more vanilla and less chocolate.and less chocolate.

If MUIf MUvv/P/Pvv < MU < MUcc/P/Pc c then buy more then buy more chocolate and less vanilla.chocolate and less vanilla.

1616

Pints/yr

Mar

gina

l util

ity o

f van

illa

ice

crea

m

(util

s/ p

int)

12

200

8

300

Sarah increases vanillaspending by $100, andMUV/PV = 8/$1 = 8

VanillaVanilla

1717

ChocolateChocolate

Mar

gina

l util

ity o

f cho

cola

te ic

e cr

eam

(util

s/ p

int)

Pints/yr

16

100

24

50

Sarah decreases chocolatespending by $100, andMUC/PC = 24/$2 = 12 >MUV/pV = 8

1818

Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?Total Utility?

Can she improve her position?Can she improve her position?Use the rational decision-making rule.Use the rational decision-making rule. Is MU per $ of vanilla greater or less than Is MU per $ of vanilla greater or less than

MU per $ of chocolate?MU per $ of chocolate?MU/P of vanilla was $8 and MU/P of MU/P of vanilla was $8 and MU/P of

chocolate was $12.chocolate was $12.So Sarah should buy more chocolate and So Sarah should buy more chocolate and

less vanilla.less vanilla.

1919

EquilibriumEquilibrium

Pints/yr

Mar

gina

l util

ity o

f van

illa

ice

crea

m

(util

s/ p

int)

10

250

110

VanillaPrice Vanilla

MU

2020

EquilibriumEquilibrium

Mar

gina

l util

ity o

f cho

cola

te ic

e cr

eam

(util

s/ p

int)

Pints/yr

20

75

220

Chocolate PriceChocolate

MU

2121

EquilibriumEquilibriumBudget = $400Budget = $400PPCC = = $2 & $2 & PPVV = $1 = $1QQCC = 75 & = 75 & QQVV = 250 = 250

110

PMU

220

PMU

V

V

C

C

2222

The Rational Spending RuleThe Rational Spending RuleSpending should be allocated across goods Spending should be allocated across goods

so that the marginal utility per dollar is the so that the marginal utility per dollar is the same for each good.same for each good.

V

V

C

C

PMU

PMU

2323

Price of chocolate falls to $1Price of chocolate falls to $1

110

PMU

120

PMU

V

V

C

C

2424

Applying theApplying theRational Spending RuleRational Spending Rule

Why do the wealthy in Manhattan live in smaller Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle?houses than the wealthy in Seattle?

Why did people turn to four-cylinder cars in the Why did people turn to four-cylinder cars in the 1970s only to shift back to six- and eight-cylinder 1970s only to shift back to six- and eight-cylinder cars in the 1990s?cars in the 1990s?

Why are automobile engines smaller in England Why are automobile engines smaller in England than in the United States?than in the United States?

Why are waiting lines longer in poorer Why are waiting lines longer in poorer neighborhoods?neighborhoods?

2525

Individual and Market Individual and Market Demand Curves for Canned TunaDemand Curves for Canned Tuna

Pric

e ($

/can

)

Smith’s quantity

1.20

6

1.40

1.60

1.00

.80

.60

.40

.20

0

(cans/week)

2 4 8Pr

ice

($/c

an)

Jones’s quantity60

(cans/week)

2 4

Smith Jones+

Horizontal Addition

1.20

1.40

1.60

1.00

.80

.60

.40

.20

2626

Individual and Market Individual and Market Demand Curves for Canned TunaDemand Curves for Canned Tuna

Pric

e ($

/can

)

Total quantity60

(cans/week)

2 4 8 1210

=

MarketDemandcurve

1.20

1.40

1.60

1.00

.80

.60

.40

.20

2727

The Individual and Market Demand Curves The Individual and Market Demand Curves When All Buyers Have Identical Demand CurvesWhen All Buyers Have Identical Demand Curves

Pric

e ($

/can

)

Quantity

6

6

5

4

3

2

1

0

(cans/month)

2 4 8 1210

D

Quantity

6

6

5

4

3

2

1

0

(1000s of cans/month)

2 4 8 1210

D

Pric

e ($

/can

)

•Each of 1,000 consumers have the same demand•Market Demand = P x number of consumers (1,000)

2828

Consumer SurplusConsumer SurplusThe difference between a buyer’s The difference between a buyer’s

reservation price for a product and the reservation price for a product and the price actually paid.price actually paid.

P

2929

Supply and Demand Supply and Demand in the Market for Milkin the Market for Milk

Quantity (1,000s of gallons/day)

Pric

e ($

/gal

lon)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

S

D

3030

Consumer Surplus Consumer Surplus in the Market for Milkin the Market for Milk

Quantity (1,000s of gallons/day)

Pric

e ($

/gal

lon)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

S

D

Consumer surplus •h = $1/gallon•b = 4,000•Consumer surplus = (1/2)(4,000)(1) = $2,000/day