Frank and Bernanke

1
Chapter 5
Demand The Benefit Side of The Market

• Frank and Bernanke

2
The Law of Demand

• People do less of what they want to do as the
  cost of doing it rises

3
The Law of Demand

• The benefit of an activity equals the highest
  price wed 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.

4
The Law of Demand

• The Origins of Demand
• What determines tastes or preferences?
• Biology
• Culture
• Peer Influences

5
Translating Wants into Demand

• How should we allocate our incomes among the
  various goods and services that are available?

6
Translating Wants into Demand

• Measuring Wants The Concept of Utility
• Utility
• The satisfaction people derive from their
  consumption activities
• Assumption
• People allocate their income to maximize their
  satisfaction or total utility

7
What is utility
Utility is a word economists use for the
satisfaction consumers derive from goods and
services.
Economists assume that consumers are rational,
that is that they choose the items that give them
the most satisfaction.
8
Marginal Utility
When economists use the term marginal, they
mean additional or extra. Hence, marginal
utility denotes the additional utility arising
from consumption of an additional unit of a
commodity.
9
Law of Diminishing Marginal Utility
Total utility tends to increase as one consumes
more of a good. However, the additional utility
gained from adding more units of the
commodity declines.
Example Morning coffee. The first cup is
always the best. I would choose the first cup
of coffee over a donut, but I would pick coffee
and a donut over two cups of coffee.
10
Numerical Example
Q Total Utility Marginal Utility 0
0 1 4 4 2
7 3 3 9 2
11
Sarahs Total Utility from Ice Cream Consumption
Cone quantity (cones/hour) Total utility
(utils/hour)
0 0 1 50 2 90 3 120 4 140 5 150 6 1
40
How much ice cream should Sarah consume if the
ice cream is free?
12
Sarahs Total Utility from Ice Cream Consumption
150
140
120
90
Utils/hour
50
0
1
3
4
5
6
2
Cones/hour
13
Sarahs Total Utility and Marginal Utility from
Ice Cream Consumption
Cone quantity Total utility Marginal
utility (cones/hour) (utils/hour) (utils/cone)
__
0 0 1 50 2 90 3 120 4 140 5 150 6 1
40
50 40 30 20 10 -10
14
Diminishing Marginal Utility
50
40
30
Utils/cone
20
10
0
1
2
3
4
1.5
0.5
2.5
3.5
4.5
Cones/hour
15
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

16
Translating Wants into Demand

• Allocating A Fixed Income Between Two Goods
• Assume
• Two goods Chocolate and vanilla ice cream
• Price of chocolate equals 2/pint
• Price of vanilla equals 1/pint
• Sarahs budget 400/yr
• Currently Sarah is consuming 200 pints of vanilla
  and 100 pints of chocolate

17
Translating Wants into Demand

• Question
• Is Sarah maximizing her total utility?

18
Marginal Utility Curves for Two Flavors of Ice
Cream (I)
Marginal utility of chocolate ice cream (utils/
pint)
Marginal utility of vanilla ice cream (utils/
pint)
16
12
200
100
Pints/yr
Pints/yr
19
Translating Wants into Demand

• Marginal utility vanilla/P
• 12/1 12 utils/
• Marginal utility chocolate/P
• 16/2 8 utils/

20
Translating Wants into Demand

• 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

21
Marginal Utility Curves for Two Flavors of Ice
Cream (II)
Sarah increases vanilla spending by 100,
and MUV/PV 8/1 8
Marginal utility of vanilla ice cream (utils/
pint)
12
8
200
300
Pints/yr
22
Marginal Utility Curves for Two Flavors of Ice
Cream (II)
Sarah decreases chocolate spending by 100,
and MUC/PC 24/2 12 MUV/pV 8
24
Marginal utility of chocolate ice cream (utils/
pint)
16
100
50
Pints/yr
23
Marginal Utility Curves for Two Flavors of Ice
Cream (III)
Marginal utility of vanilla ice cream (utils/
pint)
10
250
Pints/yr
24
Marginal Utility Curves for Two Flavors of Ice
Cream (III)
20
Marginal utility of chocolate ice cream (utils/
pint)
75
Pints/yr
25
Translating Wants into Demand

• The Rational Spending Rule
• Spending should be allocated across goods so that
  the marginal utility per dollar is the same for
  each good.

26
Example Problem
Bill spends all his money on chips and soda. The
marginal utility of the last bag of chips is 30
and the price is 3. If soda costs 2.00, what
must the marginal utility equal for Bill to be at
consumer equilibrium. At equilibrium
MUchips/price-chips MUsoda/price-soda.
I
Price MU chips 3
30 soda 2 ____
?
27
Example, Solution
To be in equilibrium 30/3 10 X/2 Solve
for X X 20 Check 20/210
I
Price MU chips 3
30 soda 2 _20__
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Expenditures on Two Goods
The total expenditure on two goods is P1q1
P2q2 In the previous example, if Bill buys 20
bags of chips and 15 bottles of soda he
spends 203 152 60
29
Graphing his budget
If the total amount he has available to spend on
chips and soda is 60, you can graph the budget
constraint by finding the two axis intercepts.
chips
60/3
20
60/2
30 soda
30
Translating Wants into Demand

• The Rational Spending Rule
• How is the rational spending rule related to the
  cost-benefit principle?

31
Translating Wants into Demand

• Income and Substitution Effects Revisited
• How should Sarah respond to a reduction in the
  price of chocolate ice cream?

32
Marginal Utility Curves for Two Flavors of Ice
Cream (III)
Marginal utility of chocolate ice cream (utils/
pint)
Marginal utility of vanilla ice cream (utils/
pint)
20
10
250
75
Pints/yr
Pints/yr
33
Translating Wants into Demand

• Assume
• Budget 400
• PC 2 PV 1
• QC 75 QV 250

34
Translating Wants into Demand

• Assume
• Price of chocolate falls to 1

35
Equimarginal Principle
A consumer with a fixed income, facing given
market prices for goods, will maximize utility
when the marginal utility of the last dollar
spent on each good is exactly the same as the
marginal utility from the last dollar spent on
any other good.
36
Mathematical approach
Maximize Utility U(X1,X2, X3 . . . .XN)
Subject to the budget constraint P1X1 P2X2
. . . PNXN Income
37
Solution
This problem can be set up as a constrained
optimization problem (Lagrangian).
The solution (using Calculus) yields the
result MUgood1 MUgood2 MUgoodN
________ ________ _________


P1 P2
PN
38
Downward sloping demand
Under marginal utility theory, demand has to
slope downward because as the price of a good
goes up, the ratio MUgood1
P1 will fall. To get the
ratio back in line with those of other goods,
less of good 1 must be purchased, to raise the
numerator by an offsetting amount.
39
Equilibrium
Coffee costs 1 a cup and muffins cost 2. A
consumer spends all income on these 2 items. If
MU of last cup of coffee is 10 and the MU of
last muffin is 30, is this consumer in
equilibrium?
Answer No. MU/P 10 for coffee MU/P 15
for muffins The consumer should buy more muffins
and fewer cups of coffee.
40
MU and reservation price
If you are deciding whether to purchase an item,
you would consider the MU of the purchase per
dollar spent. If that ratio is at least as great
as what you could get from alternative uses of
the money, you would be willing to make the
purchase. Thus the reservation price is the
price so that MU/P ?, where ? is the MU
youd get from a dollar spent at the best
alternative use.
41
An Indifference Curve
At point A, the consumer would choose 9 burgers
and 17 pizzas.
pizza
A
17

burgers

9
42
An Indifference Curve
At point B, the consumer would choose 16 burgers
and 8 pizzas.
pizza
A
17
B
8
burgers

9 16
43
An Indifference Map
Good 1
Each curve represents a set of choices that the
consumer is indifferent between. The
consumer prefers the sets furthest from
the origin.
U3
U2
U1
Good 2
44
A Pair of Indifference Curve
pizza
U2 is preferred to U1.
U2
U1
11
5
burgers

10

45
The Budget Constraint
The consumer is constrained by a budget. The
problem is to achieve the highest level of
satisfaction for a given income. The higher
the indifference curve, the better.
46
Budget Constraint
Income Pgood1quantity of good 1
Pgood2quantity of good 2
47
Example
If income is 96, pizza costs 6.00 and burgers
3.00, I can afford 16 pizzas, and no
burgers 12 pizzas, and 8 burgers 8 pizzas and
16 burgers no pizzas, and 32 burgers and a
variety of other combinations along the budget
line.
48
Graphing the budget line
Find the maximum number of each commodity you
could buy (if you didnt buy the other).
Example 16 pizzas (no burgers) 32 burgers (no
pizza) Make a line connecting the points.
49
Slope of the budget constraint
The slope of the budget constraint is equal to
the price ratio.
50
The Budget Constraint
pizza


Slope 3/6 1/2

16

burgers

32

51
Putting things together
The consumer can reach a point on U2, but no
points on U3. The consumer can reach many
points on U1, but the point on U2 is preferred
to all of the points on U1.
pizza
U3
U2
U1

16
.
burgers

32

52
The consumer decides
pizza
U3

The choice is C on U2! 20 burgers and 6 pizzas.
U2
U1

16
.
C
6
burgers

20
32

53
Point of Tangency
The consumers choice is the point where the
budget constraint is just tangent (touching in
one point) to the highest attainable indifference
curve.
54
Suppose income goes up
If income rises to 120, the budget constraint
shifts up. At the same prices, the consumer
can get 20 pizzas and no burgers, 40 burgers and
no pizza, or any combination on the line joining
these points.
55
New Budget Constraint
pizza

The slope of the two lines is the same. The
slope is the ratio of the two prices, so the
slope is still 1/2 (3/6).


20

16
burgers

32 40


56
When income is 120
The consumer can now reach a point on U3. At
point D, the consumer will choose 24 burgers and
8 pizzas.
pizza
U2
U3
U1
20

16
D
.

32 40


57
Now let price change.
Return to the original income of 96. This time,
let pizza price fall from 6.00 to 4.00 with
burger price still 3.00.
I have to redraw the budget constraint. I can now
buy 24 pizzas and no burgers, no pizzas and 32
burgers or any point on the line between.
58
Income is 96, pizza price is 4.00, burger price
is 3.00
pizza
When a price changes, the budget constraint
pivots. It has a new slope, because the price
ratio is different. The new slope is 3/4.
24

16

32


59
Income is 96, pizza price is 4.00
The consumer can reach the same indifference
curve U3 as she could when income was 120.
pizza
U3
U2
24
At point E, the consumer chooses 16 burgers
and 12 pizzas.

16
.
E
.
C

32


60
Individual and Market Demand Curves for Canned
Tuna
Horizontal Addition
1.60
1.60
1.40
1.40
1.20
1.20
1.00
1.00
Price (/can)
Price (/can)
.80
.80
.60
.60

.40
.40
Smith
Jones
.20
.20
0
0
6
2
4
8
6
2
4
Smiths quantity
Joness quantity
(cans/week)
(cans/week)
61
Individual and Market Demand Curves for Canned
Tuna
1.60
1.40
1.20
1.00
Price (/can)
.80
Market Demand curve
.60

.40
.20
0
6
2
4
8
12
10
Total quantity
(cans/week)
62
The Individual and Market Demand Curves When All
Buyers Have Identical Demand Curves

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

6
6
5
5
4
4
Price (/can)
Price (/can)
3
3
2
2
1
1
D
D
0
0
6
2
4
8
12
10
6
2
4
8
12
10
Quantity
Quantity
(cans/month)
(1000s of cans/month)
63
Demand and Consumer Surplus

• Consumer Surplus
• The difference between a buyers reservation
  price for a product and the price actually paid

64
A Market with a Digital Demand Curve
12
11
10
9
8
7
Marginal utility of vanilla ice cream (utils/
pint)
6
5
4
3
2
Demand
1
1
2
3
4
5
6
7
8
9
10
11
12
0
Units/day
65
Consumer Surplus
12
Consumer surplus 15/day
11
10
9
8
7
Marginal utility of vanilla ice cream (utils/
pint)
6
5
4
3
2
Demand
1
1
2
3
4
5
6
7
8
9
10
11
12
0
Units/day
66
Demand and Consumer Surplus

• Question
• How much do buyers benefit from their
  participation in the market for milk?

67
Supply and Demand in the Market for Milk
S
3.00
2.50
Price (/gallon)
2.00
1.50
1.00
D
.50
1
2
3
4
5
6
7
8
9
10
11
12
0
Quantity (1,000s of gallons/day)
68
Consumer Surplus in the Market for Milk

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

Consumer surplus
S
3.00
2.50
Price (/gallon)
2.00
1.50
1.00
D
.50
1
2
3
4
5
6
7
8
9
10
11
12
0
Quantity (1,000s of gallons/day)